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Price Overreactions in the Forex and Trading Strategies

Last Updated on 10 February, 2024 by Rejaul Karim

In the Economics and Finance Working Paper “Price Overreactions in the Forex and Trading Strategies” Series No. 19-09, Guglielmo Maria Caporale and Alex Plastun aim to uncover the phenomena of price overreactions within the foreign exchange (FOREX) market and its implications for trading strategies.

The study scrutinizes daily and intraday data on major exchange rates such as EURUSD, USDJPY, USDCAD, AUDUSD, and EURJPY over an extended period from 2008 to 2018. Through a dynamic trigger approach and robust statistical techniques, the authors set out to test hypotheses regarding intraday patterns and price dynamics during overreaction events.

The findings reveal notable disparities in intraday dynamics between overreaction and normal days, highlighting the discernible patterns in price movements during overreaction events. Moreover, the study unveils a significant tendency for prices to revert after an overreaction, presenting an intriguing opportunity for trading anomalies.

The existence of trading strategies that capitalize on the observed anomalies underscores the presence of market inefficiencies in the FOREX, underscoring the implications of price overreactions for trading strategies and market dynamics.

Abstract Of Paper

This paper explores price overreactions in the FOREX by using both daily and intraday data on the EURUSD, USDJPY, USDCAD, AUDUSD and EURJPY exchange rates over the period 01.01.2008-31.12.2018. It applies a dynamic trigger approach to detect overreactions and then various statistical methods, including cumulative abnormal returns analysis, to test the following hypotheses: the intraday behaviour of hourly returns on overreaction days is different from that on normal days (H1), there are detectable patterns in intraday price dynamics on overreaction days (H2) and on the following days (H3). The results suggest that there are statistically significant differences between intraday dynamics on overreaction and normal days respectively; also, prices tend to change in the direction of the overreaction during the overreaction day, but move in the opposite direction on the following day. Finally, there exist trading strategies that generate abnormal profits by exploiting the detected anomalies, which can be seen as evidence of market inefficiency.

Original paper – Download PDF

Here you can download the PDF and original paper of Price Overreactions in the Forex and Trading Strategies.

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Author

Guglielmo Maria Caporale
Brunel University London – Department of Economics and Finance; London South Bank University; CESifo (Center for Economic Studies and Ifo Institute); German Institute for Economic Research (DIW Berlin)

Alex Plastun
Sumy State University

Conclusion

Through a thorough investigation into price overreactions in the FOREX market and their impact on trading strategies, Guglielmo Maria Caporale and Alex Plastun have unearthed compelling evidence of market inefficiencies.

The discerned disparities in intraday dynamics between overreaction and normal days, coupled with the observable tendency for prices to revert after an overreaction, have far-reaching implications for trading strategies and market participants.

The identification of trading strategies that yield abnormal profits by capitalizing on the detected anomalies serves as a testament to the presence of market inefficiency, underlining the potential for strategic gains within the FOREX market.

As such, the study offers invaluable insights into the intricacies of price overreactions, calling for a reevaluation of trading practices and providing a compelling case for exploiting anomalies to achieve superior returns within the dynamic landscape of the FOREX market.

Related Reading:

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Equity Tail Risk and Currency Risk Premiums

FAQ

Q1: What is the main focus of the Economics and Finance Working Paper “Price Overreactions in the Forex and Trading Strategies” by Guglielmo Maria Caporale and Alex Plastun?

A1: The main focus of the paper is to explore the phenomena of price overreactions within the foreign exchange (FOREX) market. The authors analyze daily and intraday data on major exchange rates over an extended period from 2008 to 2018, aiming to detect overreactions and examine intraday patterns and price dynamics during such events.

Q2: How does the study approach the detection of price overreactions in the FOREX market, and what statistical methods are employed?

A2: The study employs a dynamic trigger approach to detect price overreactions in the FOREX market. Various statistical methods, including cumulative abnormal returns analysis, are then used to test hypotheses related to intraday behavior, intraday price dynamics on overreaction days, and subsequent days.

Q3: What are the key findings of the study regarding intraday dynamics on overreaction and normal days, as well as the implications for trading strategies?

A3: The study finds statistically significant differences in intraday dynamics between overreaction and normal days. It reveals detectable patterns in intraday price dynamics on overreaction days and the following days. Notably, prices tend to change in the direction of the overreaction during the overreaction day but move in the opposite direction on the following day. The existence of trading strategies that generate abnormal profits by exploiting these anomalies is identified, providing evidence of market inefficiency.

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