Investor Overconfidence and the Forward Premium Puzzle

Burnside, A. Craig; Han, Bing; Hirshleifer, David; Wang, Tracy Yue

doi:10.2139/ssrn.841038

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Investor Overconfidence and the Forward Premium Puzzle

58 Pages Posted: 27 Mar 2008 Last revised: 31 Mar 2010

See all articles by A. Craig Burnside

A. Craig Burnside

Duke University - Department of Economics; University of Glasgow - Department of Economics; National Bureau of Economic Research (NBER)

Bing Han

University of Toronto, Rotman School of Management

David Hirshleifer

University of Southern California - Marshall School of Business - Finance and Business Economics Department; National Bureau of Economic Research (NBER)

Tracy Yue Wang

University of Minnesota - Twin Cities - Carlson School of Management

There are 3 versions of this paper

Date Written: March 1, 2010

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.

Keywords: investor overconfidence, forward discount puzzle, inflation differential, exchange rate overshooting, market efficiency, Purchasing Power Parity

JEL Classification: G10, G12

Suggested Citation: Suggested Citation

Burnside, Craig and Han, Bing and Hirshleifer, David and Wang, Tracy Yue, Investor Overconfidence and the Forward Premium Puzzle (March 1, 2010). Available at SSRN: https://ssrn.com/abstract=841038 or http://dx.doi.org/10.2139/ssrn.841038