Working Paper: CEPR ID: DP7791
Authors: Francis Breedon; Dagfinn Rime; Paolo Vitale
Abstract: Using a market microstructure analytical framework we decompose the FX forward discount bias into elements due to time-varying risk premia (related to EBS order flow) and forecast errors derived using the Reuters survey of FX market participants. We find that both elements are significant contributors to the forward bias with risk premia being particularly important in currency pairs traditionally associated with carry trade activity. Part of order flow is driven by carry trade, and from our decomposition the carry trade driven risk premia account for about 50% of the forward bias.
Keywords: carry trade; forward discount puzzle; fx microstructure; survey data
JEL Codes: D82; G14; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forward discount bias (G41) | components attributable to time-varying risk premia (G19) |
| forward discount bias (G41) | components attributable to forecast errors (G17) |
| risk premia (G22) | forward discount bias (G41) |
| order flow (C69) | expected risk premia (G17) |
| carry trade strategies (G15) | order flow (C69) |
| dollar expected to appreciate against yen (F31) | positive order flow (C69) |
| order flow (C69) | forward discount bias (G41) |