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Exchange Rates Under Robustness: The Forward Premium Puzzle and Delayed Overshooting ∗

We show that the forward premium puzzle and the delayed overshooting of exchange rates can be rationalized by a desire for robustness against model misspecification. Specifically, optimizing agents that are uncertain about their model of the interest rate differential will make forecasts and portfolio decisions that are less sensitive to news than standard Bayesian updating. In equilibrium, this underreaction in the bond market generates the anomalies in the foreign exchange market. To provide an intuitive interpretation of the biases induced by robustness, we establish a link with the empirical literature on distorted beliefs via Girsanov-like change of measure results that transform uncertainty sets into distortions of the parameters of the probability distribution of the data-generating process. This transformation allows us to derive closed-form solutions to the agent’s problem and the equilibrium exchange rate that have the same form as a standard rational expectations equilibrium.