Prospect Theory and Currency Returns: Empirical Evidence

70 Pages Posted: 10 Jul 2020 Last revised: 18 Sep 2020

See all articles by Qi Xu

Qi Xu

Zhejiang University - School of Economics and Academy of Financial Research

Roman Kozhan

University of Warwick - Warwick Business School

Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School; Centre for Economic Policy Research (CEPR)

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Date Written: June 17, 2020

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

Suggested Citation

Xu, Qi and Kozhan, Roman and Taylor, Mark Peter, Prospect Theory and Currency Returns: Empirical Evidence (June 17, 2020). Available at SSRN: https://ssrn.com/abstract=3629061 or http://dx.doi.org/10.2139/ssrn.3629061

Qi Xu

Zhejiang University - School of Economics and Academy of Financial Research

Yuquan Campus 38 Zheda Road
Hangzhou, Zhejiang 310027
China

Roman Kozhan

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Mark Peter Taylor (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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