Extrapolative Beliefs and Exchange Rate Markets

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This paper attempts to understand exchange rate dynamics and potential drivers of excess return predictabilities in exchange rate markets. Using a board data sample, the paper finds that countries with higher contemporaneous interest rates earn initial excess positive bond returns. However, the sign of excess returns is a function of time. In the medium run, higher contemporaneous interest rates reverse to predict negative excess returns. Interest differentials have no excess return predictabilities in the long run. To reconcile these empirical patterns, I propose that investors not only rely on fundamentals (interest differentials) but also extrapolate past exchange rates when forming expectations of future exchange levels. The proposed extrapolative model can reconcile excess return patterns as observed in the data as well as is consistent with survey evidence from investor forecasts.

Last updated on 11/09/2018