Exchange Rate Puzzles and Distorted Beliefs Pierre-Olivier Gourinchas∗

We propose a new explanation for the foreign exchange forward-premium and delayed-overshooting puzzles. We show that both puzzles arise from a systematic distortion in investorss beliefs about the interest rate process. Accordingly, the forward premium is always a biased predictor of future depreciation; the bias can be so severe as to lead to negative coefficients in the Fama regression. Delayed overshooting may or may not occur depending upon the persistence of interest rate innovations and the degree of misperception. We document empirically the extent of this distortion using survey data for G-7 countries against the U.S. and Þnd that it is strong enough to account for these irregularities