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Foreign exchange predictability and the carry trade: A decomposition approach

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  • Anatolyev, Stanislav
  • Gospodinov, Nikolay
  • Jamali, Ibrahim
  • Liu, Xiaochun

Abstract

In this paper, we decompose currency returns into multiplicative sign and absolute return components, which exhibit much greater predictability than raw returns, and use the joint conditional distribution of these components to obtain forecasts of future exchange rate returns. Our results suggest that the decomposition model produces higher forecast and directional accuracy than any of the competing models. We undertake trading exercises using carry trade returns and show that the forecasting gains translate into economically and statistically significant (risk-adjusted) profitability when trading individual currencies or forming currency portfolios based on the predicted returns from the decomposition model.

Suggested Citation

  • Anatolyev, Stanislav & Gospodinov, Nikolay & Jamali, Ibrahim & Liu, Xiaochun, 2017. "Foreign exchange predictability and the carry trade: A decomposition approach," Journal of Empirical Finance, Elsevier, vol. 42(C), pages 199-211.
    • Handle: RePEc:eee:empfin:v:42:y:2017:i:c:p:199-211
    DOI: 10.1016/j.jempfin.2017.03.005
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    2. Qian Zhang & Kuo-Jui Wu & Ming-Lang Tseng, 2019. "Exploring Carry Trade and Exchange Rate toward Sustainable Financial Resources: An application of the Artificial Intelligence UKF Method," Sustainability, MDPI, vol. 11(12), pages 1-26, June.
    3. Lumengo Bonga-Bonga & Tebogo Maake, 2021. "The Relationship between Carry Trade and Asset Markets in South Africa," JRFM, MDPI, vol. 14(7), pages 1-13, July.
    4. Jamali, Ibrahim & Yamani, Ehab, 2019. "Out-of-sample exchange rate predictability in emerging markets: Fundamentals versus technical analysis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 61(C), pages 241-263.
    5. Fu, Hsuan & Luger, Richard, 2022. "Multiple testing of the forward rate unbiasedness hypothesis across currencies," Journal of Empirical Finance, Elsevier, vol. 68(C), pages 232-245.

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    More about this item

    Keywords

    Exchange rate forecasting; Carry trade; Return decomposition; Copula; Joint predictive distribution;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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