Nominal interest rates reflect investor expectations about future inflation. If investors rationally forecast inflation, then (assuming perfect-market and risk-neutrality) currencies in which bonds offer high nominal interest rates should on average depreciate relative to low-nominal-interest-rate currencies. Furthermore, when the interest rate differential is higher than usual, the rate of depreciation should be higher than usual.
A strong empirical finding, however, is that at times when short-term nominal interest rates are high in one currency relative to another, that currency subsequently appreciates on average (see, e.g., surveys of Hodrick 1987, Lewis 1995, and Engel 1996). An equivalent finding is that the forward discount (defined as the difference between the forward and spot exchange rates) negatively forecasts subsequent exchange rate changes, a pattern known as the forward discount puzzle.
The most extensively explored explanation for the forward discount puzzle is that it reflects time-varying rational premia for systematic risk (e.g., Fama 1984). However, the survey of Hodrick (1987) concludes that “we do not yet have a model of expected returns that fits the data” in foreign exchange markets; Engel (1996) similarly concludes that models of equilibrium risk premia do not explain the strong negative relation between the forward discount and the future exchange rate change for any degree of risk aversion, even when nonstandard utility functions are employed. He therefore suggests that an approach based upon imperfect rationality can potentially offer new insights about the puzzle.
We propose here an explanation for the forward discount puzzle based upon investor overconfidence, a well-documented psychological bias. According to DeBondt and Thaler (1995), overconfidence is “perhaps the most robust finding in the psychology of judgement.” Our approach is based upon a large body of evidence from cognitive psychological experiments and surveys indicating that people, including those from various professional fields, overes-timate the accuracy of their judgments in various setting. Consistent with overconfidence, Froot and Frankel (1989) provide evidence of overreaction in currency traders’ expectations about future exchange rate depreciations. Furthermore, survey evidence indicates that currency market professionals tend to overestimate the precision of their information signals (Oberlechner and Osler 2007).
A growing analytical and empirical literature has argued that investor overconfidence explains puzzling patterns in stock markets of return predictability, return volatility, volume of trading, and individual trading losses (see Hirshleifer (2001) and Barberis and Thaler (2003) for recent reviews). If a systematic bias such as overconfidence causes anomalies in stock markets, it should also leave footprints in bond and foreign exchange markets, and vice versa. A behavioral explanation for anomalies is more credible if it can explain a range of patterns across different kinds of markets, thereby obviating the need to tailor a different theory for each anomaly and type of market.
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Investor Overconfidence and the Forward Discount Puzzle
