Prospect Theory and Currency Returns: Empirical Evidence

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 under-perform low prospect theory value currencies. The predictability is higher when arbitrage is limited and during periods of excess speculative demand of irrational 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

JEL Classification: F31, G12, G15, G40