Mispricing and Risk Premia in Currency Markets

Abstract

Using real-time data, we show that currency excess return predictability is in part due to mispricing. First, the risk-adjusted profitability of systematic currency trading strategies decreases after dissemination of the underlying academic research, suggesting that market participants learn about mispricing from publications. Moreover, the decline is greater for strategies with larger in-sample profits and lower arbitrage costs. Second, the effect of comprehensive risk adjustments on trading profits is limited, and signal ranks and alphas decay quickly. The finding that analysts’ forecasts are inconsistent with currency predictors implies that investors’ trading contributes to mispricing and suggests biased expectations as a possible explanation.

Keywords: Predictors, anomalies, mispricing, analysts, market efficiency, real-time, point-in-time, arbitrage costs, IPCA, instrumented principal components analysis

JEL Classification: F31, G12, G15