A Sentiment-Based Explanation of the Forward Premium Puzzle

51 Pages Posted: 21 Dec 2009 Last revised: 25 Sep 2015

See all articles by Jianfeng Yu

Jianfeng Yu

Tsinghua University - PBC School of Finance

Date Written: March 1, 2013

Abstract

A sentiment-based model of the exchange rate is proposed to understand the forward premium puzzle. Agents over- or underestimate the growth rate of the economy. All else equal, when perceived domestic growth is higher than perceived foreign growth, the domestic interest rate is higher than the foreign interest rate. At the same time, an econometrician would expect an increase in the home currency value. Together, the model with investor misperception can account for the forward premium puzzle. In addition, it helps lower correlation between consumption growth differentials and exchange rate growth. Finally, this paper provides empirical evidence supporting the mechanism in the sentiment-based explanation.

Keywords: investor sentiment, forward premium puzzle, long-run risk, Backus-Smith puzzle

JEL Classification: G12, F31, G14, G15

Suggested Citation

Yu, Jianfeng, A Sentiment-Based Explanation of the Forward Premium Puzzle (March 1, 2013). Journal of Monetary Economics, Vol. 60, 2013, Available at SSRN: https://ssrn.com/abstract=1524449 or http://dx.doi.org/10.2139/ssrn.1524449

Jianfeng Yu (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing 100083
China

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