Exchange Rate Dynamics, Learning and Misperception

Abstract

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 coeffcients 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 U.S., these puzzles can be rationalized for values of the model's parameters that match empirical estimates.

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