The Role of Endogenous Uncertainty in the Forward Discount Bias

This study examines what role the concept of endogenous uncertainty can have in explaining a phenomenon of international financial markets, the forward discount bias. The forward discount bias puzzle is unexplained by models assuming economic agents have full knowledge of the structure of the economy. This puzzle is explained here by constructing an overlapping generations model of a Rational Belief Equilibrium in a non-stationary environment where agents do not know the true probability distribution underlying asset price movements. The agents’ beliefs are rational in the sense that their predictions of long term averages of economic variables match historical data. The equilibrium of the model is solved numerically using the nonlinear equation solver TENSOLVE, which is well-suited to models containing multiple financial assets. The results confirm the underlying hypothesis that propagation of the beliefs of economic agents can play an important role in understanding international financial markets