A sentiment-based explanation of the forward premium puzzle

•This paper shows that investor sentiment helps account for the forward premium puzzle.•The same mechanism helps account for other stylized facts in international markets.•This study provides empirical support for the underlying mechanism of the model.

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.