Discussion paper

DP3725 Exchange Rate Dynamics, Learning and Misperception

We propose a new explanation for the forward-premium and the delayed-overshooting puzzles. Both puzzles arise from a systematic under-reaction of short-term interest rate forecasts to current innovations. 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 under-reaction; lastly, for G-7 countries against the US, these puzzles can be rationalized for values of the model's parameters that match empirical estimates.

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Citation

Tornell, A and P Gourinchas (2003), ‘DP3725 Exchange Rate Dynamics, Learning and Misperception‘, CEPR Discussion Paper No. 3725. CEPR Press, Paris & London. https://cepr.org/publications/dp3725