Investor Overconfidence and the Forward Discount Puzzle

This paper offers an explanation for the forward discount puzzle in foreign exchange markets based upon investor overconfidence. In contrast with behavioral biases conjectured specifically to explain the puzzle, overconfidence is a well-documented psychological phenomenon that has been found to be consistent with several trading and return patterns in securities markets. In our model, overconfident individuals overreact to their information about future inflation.  The spot rate and forward discount differentially reflect such overreaction; as a result, the forward discount forecasts reversal in the spot rate. The model predicts how the forward discount bias varies with time horizon, time-series versus cross-sectional test method, and shifts in volume and volatility.