The Role of Beliefs in Asset Prices: Evidence from Exchange Rates

Abstract

Motivated by evidence of systematic forecast errors by market participants and professional forecasters, we construct a model of exchange rate determination where investors each (1) receive noisy private signals about the future path of interest rate differentials between the US and other countries and (2) overestimate the persistence of interest rate differentials. Our model is able to explain the forward premium puzzle, a well-known failure of the uncovered interest rate parity condition implied by traditional models (UIP), in a manner consistent with the survey evidence, in addition to a number of additional puzzles that existing models have struggled to simultaneously explain. These include the initial underreaction and delayed overreaction of currencies in response to monetary news; positive short-horizon and negative long-horizon autocorrelations of currency excess returns; and the lower return predictability of interest rate differentials for UIP trades implemented with longer maturity bonds. Our model is also useful for understanding the strong relationship between survey-based measures of macroeconomic news and exchange rates despite the weak relationship between macroeconomic fundamentals and exchange rates, the persistence of subjective beliefs, and the seeming reversal of the failure of UIP in recent years. Our results highlight the important role that investors' beliefs may play in exchange rate behavior.