DP15306 Prospect Theory and Currency Returns: Empirical Evidence

Author(s): Roman Kozhan, Mark P Taylor, Qi Xu
Publication Date: September 2020
Keyword(s): currency returns, foreign exchange, Limits to Arbitrage, prospect theory
JEL(s): F31, G12, G15, G40
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15306

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.