Prospect Theory and Currency Returns: Empirical Evidence

90 Pages Posted: 10 Jul 2020 Last revised: 16 Jun 2023

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); Brookings Institution

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Date Written: June 17, 2020

Abstract

We empirically investigate the role of prospect theory in the foreign exchange market. A currency-level measure of prospect theory value, constructed using the historical distribution of currency returns, negatively forecasts future currency excess returns. The predictability is higher when arbitrage is limited. Banks’ order is positively associated with the prospect theory value while funds trade against it acting as arbitrageurs. The predictive ability of the prospect theory value strengthens with an increase in banks’ order flow and weakens with funds’ order flow. This is consistent with investors mentally representing currencies by their historical distributions according to the prospect theory.

Keywords: foreign exchange, currency returns, prospect theory, limits to arbitrage, order flow

JEL Classification: F31, G12, G15, G40

Suggested Citation

Xu, Qi and Kozhan, Roman and Taylor, Mark P., 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 P. 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

Brookings Institution ( email )

1775 Massachusetts Ave, NW
Washington, DC 20036
United States

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