Behavioural asymmetries in the G7 foreign exchange market

This paper examines the exchange rate disconnect puzzle of Obstfeld and Rogoff (2000) from a behavioural perspective. It provides evidence on the existence of substantial asymmetries in the underlying loss preferences for the difference between the spot and forward nominal exchange rates between the G7 countries for one-week and four-week forecast horizons. We further perform forecast breakdown tests in forward markets during the Greek and the Portuguese sovereign debt crisis, and then re-estimate the loss preferences showing a mean-reverting transition from optimism to pessimism and vice versa. Finally, we attribute the evolution of preferences to economic fundamentals and risk indexes and find that together with significant endogenous dynamics, variables such as growth and deficit differentials, interest rate and legal risk assert some significant impact on asymmetry. This new set of information suggests that the puzzle could have its roots on an underlying asymmetric loss function that reflects variability in preferences over exchange rate movements due to a variety of episodes in economic fundamentals.