Investor Overconfidence and the Forward Discount Puzzle

Bing Han, David Hirshleifer and Tracy Wang

MPRA Paper from University Library of Munich, Germany

Abstract: This paper offers an explanation for the forward discount puzzle in foreign exchange markets based upon investor overconfidence. In our model, overconfident individuals overreact to their information about future inflation differential. The spot and the forward exchange rates differentially reflect such overreaction; as a result, the forward discount forecasts reversal in the spot rate. With plausible parameter values, the model explains the magnitude of the forward discount puzzle and stylized facts about how the forward discount bias varies with time horizon and time-series versus cross-sectional test method. Furthermore, the model generates new empirical predictions about the relation between the forward discount bias to foreign exchange trading volume, exchange rate volatility and predictability, as well as the degree of violation of the relative Purchasing Power Parity.

Keywords: Uncovered Interest Parity; forward discount puzzle; inflation differential; investor overconfidence; exchange rate overshooting; market efficiency; Purchasing Power Parity (search for similar items in EconPapers)
JEL-codes: F31 G12 G14 G15 (search for similar items in EconPapers)
Date: 2005-06, Revised 2007-12
New Economics Papers: this item is included in nep-cba and nep-ifn
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Related works:
Working Paper: Investor Overconfidence and the Forward Discount Puzzle (2010)
Working Paper: Investor Overconfidence and the Forward Discount Puzzle (2005)
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:6497

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