A Transaction Data Study of the Forward Bias Puzzle

Francis Breedon, Dagfinn Rime and Paolo Vital
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Paolo Vital: University d'Annunzio
Authors registered in the RePEc Author Service: Paolo Vitale

No 2010/26, Working Paper from Norges Bank

Abstract: Using ten years of FX transactions data we demonstrate that a large share of the FX forward discount bias can be accounted for by order flow. A simple microstructure-based decomposition suggests that order flow creates a timevarying risk premium that is correlated with the forward discount. The order flow related risk premium is particularly important in currency pairs traditionally associated with carry trade activity, as for these crosses it accounts for more than half of the forward bias (with the rest accounted for by systematic forecasting errors). We also find evidence that order flow is partly driven by carry trade activity, which is itself is driven by expectations of carry trade profits. However, carry trading increases currency-crash risk in that the carry-induced order flow generates negative skewness in FX returns.

Keywords: Forward Discount Puzzle; FX Microstructure; Carry Trade; Survey Data (search for similar items in EconPapers)
JEL-codes: F31 G14 G15 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2010-12-13
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mst
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Citations: View citations in EconPapers (7)

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Working Paper: A Transaction Data Study of the Forward Bias Puzzle (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:bno:worpap:2010_26

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