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

Abstract

A long-standing challenge in the asset pricing literature is to understand why asset prices sometimes underreact and sometimes overreact to news. We seek to address this challenge in the context of currency markets. We construct a model of exchange rate determination disciplined by survey data, where short-lived 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. The model is able to qualitatively and quantitatively match patterns of underreaction and overreaction of exchange rates in response to news. The model also matches the failure of uncovered interest rate parity (UIP), capturing the return predictability of interest rate differentials for the returns to borrowing in USD and lending in foreign currency, as well as the fact that this return predictability is declining in the maturity of bonds used to borrow and lend. Finally, we use the model to help understand the reversal of the failure of UIP in recent years, the role of higher-order uncertainty, and the persistence of subjective beliefs. Our results highlight the important role that investors' beliefs may play in asset price behavior.