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Investor Overconfidence and the Forward Premium PuzzleA. Craig BurnsideDuke University - Department of Economics; University of Glasgow - Department of Economics; National Bureau of Economic Research (NBER) Bing HanUniversity of Texas at Austin - McCombs School of Business David A. HirshleiferUniversity of California, Irvine - Paul Merage School of Business Tracy Yue WangUniversity of Minnesota - Twin Cities - Carlson School of Management April 1, 2010 Economic Research Initiatives at Duke (ERID) Working Paper No. 47 McCombs Research Paper Series No. FIN-03-10 Abstract: We offer an explanation for the forward premium puzzle in foreign exchange markets based upon investor overconfidence. In the model, overconfident individuals overreact to their information about future inflation, which causes greater overshooting in the forward rate than in the spot rate. Thus, when agents observe a signal of higher future inflation, the consequent rise in the forward premium predicts a subsequent downward correction of the spot rate. The model can explain the magnitude of the forward premium bias and several other stylized facts related to the joint behavior of forward and spot exchange rates. Our approach is also consistent with the availability of profitable carry trade strategies
Number of Pages in PDF File: 61 JEL Classification: F31, G15 working papers seriesDate posted: April 27, 2010 ; Last revised: October 8, 2010Suggested CitationContact Information
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