A Sentiment-Based Explanation of the Forward Premium Puzzle

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.

Number of Pages in PDF File: 51

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

JEL Classification: G12, F31, G14, G15

working papers series