Norges Bank

Working Paper

A transaction data study of the forward bias puzzle

Author:
Francis Breedon, Dagfinn Rime and Paolo Vitale
Series:
Working Paper
Number:
26/2010

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.

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ISSN 1502-8190 (online)

Published 13 December 2010 15:30
Published 13 December 2010 15:30