Overconfidence in Currency Markets

Abstract

This paper documents two forms of overconfidence among currency market professionals: a tendency to overestimate one's professional success, and a tendency to overestimate forecast precision. The evidence is based on a 2002 survey of 416 currency market professionals in North America. Over-confidence, which is central to current debates about equity pricing, may also be related to many issues in international economics, including: the forward premium puzzle, volatility in international capital flows, and high exchange-rate volatility with its associated fear of floating. Our evidence suggests that overconfidence does not affect profitability. This is consistent with economic theory, given the tiny transactions costs in currency markets and the ambiguous relationship between currency risk and return. Nonetheless, we find that overconfidence promotes overall professional success, measured as individuals' rank and trading experience. This is consistent with psychology research, which shows that overconfidence enhances qualities such as mental facility and perseverance. We infer that overconfidence may be self-sustaining in currency markets, and its consequences for exchange-rate dynamics, if any, may be permanent.