Prospect Theory and Currency Returns: Empirical Evidence

Qi Xu, Roman Kozhan, and Mark P. Taylor

♦ We empirically investigate the role of prospect theory in the foreign exchange market. A currency-level measure of prospect-theory value, constructed from the historical distribution of exchange rate returns, negatively forecasts future currency excess returns. A long–short strategy based on this measure yields approximately 5% per annum. Predictability is stronger when arbitrage is limited. Bank order flow is positively associated with prospect-theory value, with inter-dealer and proprietary trading primarily driving this relation. Funds trade against prospect-theory value, acting as arbitrageurs. Overall, our findings suggest that investors evaluate currencies based on historical return distributions, consistent with prospect theory.

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