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Federal Reserve Bank of Dallas
Globalization Institute Working Papers
A sentiment-based explanation of the forward premium puzzle
Jianfeng Yu

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.

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Jianfeng Yu, A sentiment-based explanation of the forward premium puzzle, Federal Reserve Bank of Dallas, Globalization Institute Working Papers 90, 2011.
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Note: Published as: Yu, Jianfeng (2013), "A Sentiment-Based Explanation of the Forward Premium Puzzle," Journal of Monetary Economics 60 (4): 474-491.
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