Investor overconfidence and the forward premium puzzle

Journal Article (Journal Article)

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. © The Author 2011. Published by Oxford University Press on behalf of The Review of Economic Studies Limited.

Full Text

Duke Authors

Cited Authors

  • Burnside, C; Han, B; Hirshleifer, D; Wang, TY

Published Date

  • April 1, 2011

Published In

Volume / Issue

  • 78 / 2

Start / End Page

  • 523 - 558

Electronic International Standard Serial Number (EISSN)

  • 1467-937X

International Standard Serial Number (ISSN)

  • 0034-6527

Digital Object Identifier (DOI)

  • 10.1093/restud/rdq013

Citation Source

  • Scopus