DP7791 A Transaction Data Study of the Forward Bias Puzzle

• Paolo Vitale Dagfinn Rime Francis Breedon
23 Apr 2010

Using a market microstructure analytical framework we decompose the FX forward discount bias into elements due to time-varying risk premia (related to EBS order flow) and forecast errors derived using the Reuters survey of FX market participants. We find that both elements are significant contributors to the forward bias with risk premia being particularly important in currency pairs traditionally associated with carry trade activity. Part of order flow is driven by carry trade, and from our decomposition the carry trade driven risk premia account for about 50% of the forward bias.