Discussion paper

DP15306 Prospect Theory and Currency Returns: Empirical Evidence

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.


Xu, Q, R Kozhan and M Taylor (2020), ‘DP15306 Prospect Theory and Currency Returns: Empirical Evidence‘, CEPR Discussion Paper No. 15306. CEPR Press, Paris & London. https://cepr.org/publications/dp15306