Exchange Rate Dynamics, Learning and Misperception
University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
University of California, Los Angeles (UCLA) - Department of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)
CEPR Discussion Paper No. 3725
We propose a new explanation for the forward-premium and the delayed-overshooting puzzles. Both puzzles arise from a systematic under-reaction of short-term interest rate forecasts to current innovations. Accordingly, the forward premium is always a biased predictor of future depreciation; the bias can be so severe as to lead to negative coefficients in the 'Fama' regression; delayed overshooting may or may not occur depending upon the persistence of interest rate innovations and the degree of under-reaction; lastly, for G-7 countries against the US, these puzzles can be rationalized for values of the model's parameters that match empirical estimates.
Number of Pages in PDF File: 59
Keywords: Forward premium puzzle, delayed overshooting, predictable returns, monetary policy
JEL Classification: E40, F31, G10working papers series
Date posted: February 14, 2003
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