Forward Premium Puzzle and Heterogeneous Beliefs

57 Pages Posted: 17 Apr 2020 Last revised: 23 Jul 2020

See all articles by Benjamin Croitoru

Benjamin Croitoru

affiliation not provided to SSRN

Feng Jiao

University of Lethbridge - Faculty of Management

Lei Lu

Asper School of Business, University of Manitoba

Date Written: July 22, 2020

Abstract

We propose a two-country model with heterogeneous beliefs to understand the forward premium puzzle. Facing a shock to the domestic money supply, the disagreement between domestic and foreign investors shifts the relative wealth of investors, which moves the exchange rate and interest rate differential in opposite directions. Calibrated to U.S. and U.K. data, our model reproduces the rejection of the uncovered interest rate parity. Using a monthly index of heterogeneous beliefs based on the Consensus Forecast in 15 major economies, the empirical evidence confirms that the dispersion of beliefs helps explain exchange rate movements and carry trade returns.

Keywords: Heterogeneous beliefs; Uncovered interest rate parity; Carry trade; Exchange rate volatility

JEL Classification: D53, G10, G12

Suggested Citation

Croitoru, Benjamin and Jiao, Feng and Lu, Lei, Forward Premium Puzzle and Heterogeneous Beliefs (July 22, 2020). Available at SSRN: https://ssrn.com/abstract=3563589 or http://dx.doi.org/10.2139/ssrn.3563589

Benjamin Croitoru

affiliation not provided to SSRN

Feng Jiao

University of Lethbridge - Faculty of Management ( email )

4401 University Drive
Lethbridge, Alberta TIK 3M4
Canada

Lei Lu (Contact Author)

Asper School of Business, University of Manitoba ( email )

181 Freedman Crescent
Winnipeg, Manitoba R3T 5V4
Canada

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