Forward Premium Puzzle and Heterogeneous Beliefs
57 Pages Posted: 17 Apr 2020 Last revised: 23 Jul 2020
Date Written: July 22, 2020
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
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