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Investor Overconfidence and the Forward Premium Puzzle

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  • Craig Burnside
  • Bing Han
  • David Hirshleifer
  • Tracy Yue Wang

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 behaviour of forward and spot exchange rates. Our approach is also consistent with the availability of profitable carry trade strategies. Copyright 2011, Oxford University Press.

Suggested Citation

  • Craig Burnside & Bing Han & David Hirshleifer & Tracy Yue Wang, 2011. "Investor Overconfidence and the Forward Premium Puzzle," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 78(2), pages 523-558.
    • Handle: RePEc:oup:restud:v:78:y:2011:i:2:p:523-558
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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