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A Transaction Data Study of the Forward Bias Puzzle

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  • Francis Breedon

    ()
    (Queen Mary, University of London)

  • Dagfinn Rime

    ()
    (Norges Bank (Central Bank of Norway))

  • Paolo Vital

    ()
    (University d'Annunzio)

Abstract

Using ten years of FX transactions data we demonstrate that a large share of the FX forward discount bias can be accounted for by order flow. A simple microstructure-based decomposition suggests that order flow creates a timevarying risk premium that is correlated with the forward discount. The order flow related risk premium is particularly important in currency pairs traditionally associated with carry trade activity, as for these crosses it accounts for more than half of the forward bias (with the rest accounted for by systematic forecasting errors). We also find evidence that order flow is partly driven by carry trade activity, which is itself is driven by expectations of carry trade profits. However, carry trading increases currency-crash risk in that the carry-induced order flow generates negative skewness in FX returns.

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Bibliographic Info

Paper provided by Norges Bank in its series Working Paper with number 2010/26.

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Length: 33 pages
Date of creation: 13 Dec 2010
Date of revision:
Handle: RePEc:bno:worpap:2010_26

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Keywords: Forward Discount Puzzle; FX Microstructure; Carry Trade; Survey Data;

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Citations

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Cited by:
  1. Loring, Grace & Lucey, Brian, 2013. "An analysis of forward exchange rate biasedness across developed and developing country currencies: Do observed patterns persist out of sample?," Emerging Markets Review, Elsevier, vol. 17(C), pages 14-28.
  2. Hans Jørgen Tranvåg & Dagfinn Rime, 2012. "The Flows of the Pacific: Asian foreign exchange markets through tranquility and turbulence," Working Paper Series 12412, Department of Economics, Norwegian University of Science and Technology.
  3. Brian Lucey & Grace Loring, 2012. "Forward Exchange Rate Biasedness across Developed and Developing Country Currencies - Do Observed Patterns Persist Out of Sample?Abstract:," The Institute for International Integration Studies Discussion Paper Series iiisdp404, IIIS.

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