Investor Overconfidence and the Forward Premium Puzzle

61 Pages Posted: 5 Apr 2010 Last revised: 10 May 2023

See all articles by A. Craig Burnside

A. Craig Burnside

Duke University - Department of Economics; University of Glasgow - Department of Economics; National Bureau of Economic Research (NBER)

Bing Han

University of Toronto, Rotman School of Management

David A. Hirshleifer

Marshall School of Business, USC; National Bureau of Economic Research (NBER)

Tracy Yue Wang

University of Minnesota - Twin Cities - Carlson School of Management

Multiple version iconThere are 3 versions of this paper

Date Written: April 2010

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 behavior of forward and spot exchange rates. Our approach is also consistent with the availability of profitable carry trade strategies.

Suggested Citation

Burnside, Craig and Han, Bing and Hirshleifer, David A. and Wang, Tracy Yue, Investor Overconfidence and the Forward Premium Puzzle (April 2010). NBER Working Paper No. w15866, Available at SSRN: https://ssrn.com/abstract=1583807

Craig Burnside (Contact Author)

Duke University - Department of Economics ( email )

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University of Glasgow - Department of Economics

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National Bureau of Economic Research (NBER)

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Bing Han

University of Toronto, Rotman School of Management ( email )

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David A. Hirshleifer

Marshall School of Business, USC ( email )

Marshall School of Business
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United States

HOME PAGE: http://https://sites.uci.edu/dhirshle/

National Bureau of Economic Research (NBER) ( email )

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Tracy Yue Wang

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

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