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A sentiment-based explanation of the forward premium puzzle

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  • Jianfeng Yu

Abstract

This paper presents a sentiment-based explanation of the forward premium puzzle. Agents over- or underestimate the growth rate of the economy. All else equal, when perceived domestic growth is higher than perceived foreign growth, the domestic interest rate is higher than the foreign interest rate. At the same time, an econometrician would expect an increase in the home currency value. Together, the model with investor misperception can account for the forward premium puzzle.> ; In addition, it helps explain the low correlation of consumption growth differentials and exchange rate growth and the high stock market correlation across countries, despite a low correlation of fundamentals. Finally, this paper provides direct empirical evidence supporting the mechanism in the sentiment-based explanation.

Suggested Citation

  • Jianfeng Yu, 2011. "A sentiment-based explanation of the forward premium puzzle," Globalization Institute Working Papers 90, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddgw:90
    Note: Published as: Yu, Jianfeng (2013), "A Sentiment-Based Explanation of the Forward Premium Puzzle," Journal of Monetary Economics 60 (4): 474-491.
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    2. Loring, Grace & Lucey, Brian, 2013. "An analysis of forward exchange rate biasedness across developed and developing country currencies: Do observed patterns persist out of sample?," Emerging Markets Review, Elsevier, vol. 17(C), pages 14-28.

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    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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