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Exchange Rate Puzzles and Distorted Beliefs
with Aaron Tornell (UCLA)
Journal of International Economics, December 2004, 64(2), pp303-333
A pdf version
of the paper is available.
This is a much revised version of Exchange Rates Dynamics, Learning and Misperception, July 2001.
Here is the 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
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