Prospect Theory and Currency Returns: Empirical Evidence

73 Pages Posted: 22 Sep 2020

See all articles by Roman Kozhan

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

Qi Xu

Zhejiang University - School of Economics and Academy of Financial Research

Multiple version iconThere are 2 versions of this paper

Date Written: September 1, 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 underperform low prospect theory value currencies. The predictability is higher when arbitrage is limited and during periods of excess speculative demand of ir- rational 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: currency returns, foreign exchange, Limits to Arbitrage, prospect theory

JEL Classification: F31, G12, G15, G40

Suggested Citation

Kozhan, Roman and Taylor, Mark P. and Xu, Qi, Prospect Theory and Currency Returns: Empirical Evidence (September 1, 2020). Available at SSRN: https://ssrn.com/abstract=3696389

Roman Kozhan (Contact Author)

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Mark P. Taylor

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

Qi Xu

Zhejiang University - School of Economics and Academy of Financial Research

Yuquan Campus 38 Zheda Road
Hangzhou, Zhejiang 310027
China

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