Investor Overconfidence and the Forward Discount Puzzle

Han, Bing; Hirshleifer, David and Wang, Tracy (2005): Investor Overconfidence and the Forward Discount Puzzle. Unpublished.

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Uncovered Interest Parity, forward discount puzzle, inflation differential, investor overconfidence, exchange rate overshooting, market efficiency, Purchasing Power Parity
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency; Event Studies; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; F - International Economics > F3 - International Finance > F31 - Foreign Exchange