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Carry Trades, Order Flow, and the Forward Bias Puzzle
Author(s) -
BREEDON FRANCIS,
RIME DAGFINN,
VITALE PAOLO
Publication year - 2016
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/jmcb.12328
Subject(s) - skewness , carry (investment) , econometrics , order (exchange) , flow (mathematics) , currency , forward rate , first order , risk premium , economics , interest rate , mathematics , monetary economics , finance , geometry
We investigate the relation between foreign exchange (FX) order flow and the forward bias. We outline a decomposition of the forward bias according to which a negative correlation between interest rate differentials and order flow creates a time‐varying risk premium consistent with that bias. Using 10 years of data on FX order flow, we find that more than half of the forward bias is accounted for by order flow—with the rest being explained by expectational errors. We also find that carry trading increases currency‐crash risk in that order flow generates negative skewness in FX returns.