Prospect Theory and Currency Returns: Empirical Evidence

Mark Taylor, Qi Xu and Roman Kozhan

No 15306, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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.

Keywords: Foreign exchange; Currency returns; Prospect theory; Limits to arbitrage (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 G40 (search for similar items in EconPapers)
Date: 2020-09
New Economics Papers: this item is included in nep-cwa, nep-ifn, nep-mon, nep-opm and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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