Currency returns, market regimes and behavioral biases

Covered interest rate parity assumes that there is no risk premium on the hedged returns on currencies. However, empirical evidence indicates that risk premiums are not identically zero, and this is referred to as the forward premium puzzle. We show that there exist market regimes, within which behavioral biases affect decisions, and a type of parity holds within regimes. The foreign exchange market switches between regimes where there is a premium. This paper presents various tests for the hypotheses of currency regimes and regime dependent risk premiums. Based on the existence of regimes, a diversified currency portfolio is created with a mean-variance criterion. Using the Federal Exchange Rate Index as a proxy for the currency benchmark and the U.S. T-Bill as the risk free asset, the similarity between the benchmarks and the implied equilibrium hedged and unhedged portfolios provides evidence for regimes and decision bias. Within each regime interest rate parity is appropriate for modeling currency returns.