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Title: Prospect Theory and Currency Returns: Empirical Evidence

Author(s): Roman Kozhan, Mark P Taylor and Qi Xu

Publication Date: September 2020

Keyword(s): currency returns, foreign exchange, Limits to Arbitrage and prospect theory

Programme Area(s): International Macroeconomics and Finance

Abstract: We empirically investigate the role of prospect theory in the foreign exchange market. Using the historical distribution of exchange rate changes, we construct a currency-level measure of prospect theory value and find that it negatively forecasts future currency excess returns. High prospect theory value currencies significantly underperform low prospect theory value currencies. The predictability is higher when arbitrage is limited and during periods of excess speculative demand of ir- rational traders. These findings are consistent with the hypothesis that investors mentally represent currencies by their historical distributions or charts and evaluate the distribution in the way described by prospect theory.

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Bibliographic Reference

Kozhan, R, Taylor, M and Xu, Q. 2020. 'Prospect Theory and Currency Returns: Empirical Evidence'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15306