Working Paper: CEPR ID: DP15306
Authors: Qi Xu; Roman Kozhan; Mark Taylor
Abstract: We empirically investigate the role of prospect theory in the foreign exchangemarket. Using the historical distribution of exchange rate changes, we construct acurrency-level measure of prospect theory value and find that it negatively forecastsfuture currency excess returns. High prospect theory value currencies significantlyunderperform low prospect theory value currencies. The predictability is higherwhen arbitrage is limited and during periods of excess speculative demand of ir-rational traders. These findings are consistent with the hypothesis that investorsmentally represent currencies by their historical distributions or charts and evaluatethe distribution in the way described by prospect theory.
Keywords: foreign exchange; currency returns; prospect theory; limits to arbitrage
JEL Codes: F31; G12; G15; G40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited arbitrage and high speculative demand (G19) | predictability of prospect theory value on future currency returns (D81) |
| historical exchange rate distributions (F31) | prospect theory values (D81) |
| prospect theory value (D46) | future currency returns (F31) |