Currency returns, market regimes and behavioral biases

Leonard MacLean (), Yonggan Zhao () and William Ziemba ()

Annals of Finance, 2013, vol. 9, issue 2, 249-269

Abstract: Covered interest rate parity assumes that there is no risk premium on the hedged returns on currencies. However, empirical evidence indicates that risk premiums are not identically zero, and this is referred to as the forward premium puzzle. We show that there exist market regimes, within which behavioral biases affect decisions, and a type of parity holds within regimes. The foreign exchange market switches between regimes where there is a premium. This paper presents various tests for the hypotheses of currency regimes and regime dependent risk premiums. Based on the existence of regimes, a diversified currency portfolio is created with a mean-variance criterion. Using the Federal Exchange Rate Index as a proxy for the currency benchmark and the U.S. T-Bill as the risk free asset, the similarity between the benchmarks and the implied equilibrium hedged and unhedged portfolios provides evidence for regimes and decision bias. Within each regime interest rate parity is appropriate for modeling currency returns. Copyright Springer-Verlag Berlin Heidelberg 2013

Keywords: Forward premium puzzle; Behavioral bias; Regime switching; Interest rate parity; Currency market portfolio; C12; C13; C32; C61; F31; F37; G11 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://hdl.handle.net/10.1007/s10436-012-0220-3 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:kap:annfin:v:9:y:2013:i:2:p:249-269

Ordering information: This journal article can be ordered from
http://www.springer.com/finance/journal/10436/PS2

DOI: 10.1007/s10436-012-0220-3

Access Statistics for this article

Annals of Finance is currently edited by Anne Villamil

More articles in Annals of Finance from Springer
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().