A sentiment-based model of the exchange rate is proposed to understand the forward premium puzzle. Agents over- or under-estimate 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, misperception helps lower the correlation between consumption growth differentials and exchange rate growth. Finally, this paper provides empirical evidence supporting the mechanism in the sentiment-based explanation.
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I would like to thank Raj Aggarwal, Ravi Bansal, Frederico Belo, John Boyd, Zhi Da, Paul Gao, Bob Goldstein, Jeremy Graveline, David Hirshleifer, Philippe Jorion, Hanno Lustig, Terry Odean, Stavros Panageas, Tracy Wang, Jeffrey Wurgler, Wei Xiong, Xiaoyun Yu, and seminar participants at the University of Minnesota, University of Notre Dame, UC-Irvine, the Federal Reserve Bank of Dallas, Peking University, Tsinghua University, 2010 Econometric Society World Congress, and 2011 WFA for comments. I especially thank Riccardo Colacito (WFA discussant), Urban Jermann (the editor), an anonymous referee, and Jian Wang for extremely insightful and detailed comments. I also thank Malcolm Baker, Jeffrey Wurgler, and Yu Yuan for making their investor sentiment data available. I gratefully acknowledge financial support from Dean's small research grant at the University of Minnesota. All errors are my own.
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