Exchange rate puzzles and distorted beliefs

Pierre-Olivier Gourinchas and A Tornell

Department of Economics, Working Paper Series from Department of Economics, Institute for Business and Economic Research, UC Berkeley

Abstract: We propose a new explanation for the foreign exchange forward-premium and delayed-overshooting puzzles. We show that both puzzles arise from a systematic distortion in investors' beliefs about the interest rate process. Accordingly, the forward premium is always a biased predictor of future depreciation; the bias can be so severe as to lead to negative coefficients in the 'Fama' regression. Delayed overshooting may or may not occur depending upon the persistence of interest rate innovations and the degree of misperception. We document empirically the extent of this distortion using survey data for G-7 countries against the U.S. and find that it is strong enough to account for these irregularities. (C) 2004 Elsevier B.V. All rights reserved.

Keywords: exchange rates; beliefs; forward premium puzzle; delayed overshooting (search for similar items in EconPapers)
Date: 2004-12-01
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Citations: View citations in EconPapers (157)

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