A Transaction Data Study of the Forward Bias Puzzle

37 Pages Posted: 9 Jan 2011

See all articles by Francis Breedon

Francis Breedon

University of London, Queen Mary - School of Economics and Finance

Dagfinn Rime

BI Norwegian Business School

Paolo Vitale

G. d'Annunzio University - Dipartimento di Economia

Multiple version iconThere are 2 versions of this paper

Date Written: November 1, 2010

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.

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

JEL Classification: F31, G14, G15

Suggested Citation

Breedon, Francis and Rime, Dagfinn and Vitale, Paolo, A Transaction Data Study of the Forward Bias Puzzle (November 1, 2010). Norges Bank Working Paper 2010/26 , Available at SSRN: https://ssrn.com/abstract=1735396

Francis Breedon

University of London, Queen Mary - School of Economics and Finance ( email )

Mile End Road
London, E1 4NS
United Kingdom

Dagfinn Rime (Contact Author)

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway
+47-46410507 (Phone)

HOME PAGE: http://home.bi.no/dagfinn.rime/

Paolo Vitale

G. d'Annunzio University - Dipartimento di Economia ( email )

I-65127 Pescara, Pescara
Italy
+39 085 453 7647 (Phone)
+39 085 453 7565 (Fax)

HOME PAGE: http://www.unich.it/~vitale/

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
75
Abstract Views
890
Rank
559,388
PlumX Metrics