Can Perpetual Learning Explain the Forward Premium Puzzle?
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Date
2006-08-28
Authors
Chakraborty, Avik, 1975-
Evans, George W., 1949-
Journal Title
Journal ISSN
Volume Title
Publisher
University of Oregon, Dept of Economics
Abstract
Under rational expectations and risk neutrality the linear projection
of exchange rate change on the forward premium has a unit
coefficient. However, empirical estimates of this coefficient are significantly
less than one and often negative. We investigate whether
replacing rational expectations by discounted least squares (or “perpetual”)
learning can explain the result. We calculate the asymptotic
bias under perpetual learning and show that there is a negative bias
that becomes strongest when the fundamentals are strongly persistent,
i.e. close to a random walk. Simulations confirm that perpetual
learning is potentially able to explain the forward premium puzzle.
Description
38 p. June 30, 2006. Revised August 28, 2006.