Working Paper

A sentiment-based explanation of the forward premium puzzle

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.

JEL Classification: F31; G12; G14; G15;

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2011

Number: 90

Note: Published as: Yu, Jianfeng (2013), "A Sentiment-Based Explanation of the Forward Premium Puzzle," Journal of Monetary Economics 60 (4): 474-491.