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Can country-specific interest rate factors explain the forward premium anomaly?

Author

Listed:
  • Efthymios Argyropoulos

    (Athens University of Economics & Business
    International Monetary Fund)

  • Nikolaos Elias

    (Athens University of Economics & Business)

  • Dimitris Smyrnakis

    (Athens University of Economics & Business)

  • Elias Tzavalis

    (Athens University of Economics & Business)

Abstract

The forward premium anomaly refers to the fact that changes in spot exchange rates are negatively related to interest rate differentials between home and foreign countries, which is contrary to the predictions of the uncovered interest rate parity (UIRP). We propose a regression model of the interest rate differentials across countries (known as carry trade) adjusted for a time-varying exchange rate risk premium which can explain the anomaly and provide forecasts of exchange rate changes in accordance to the theory. The proposed model is based on estimates of the exchange rate risk premium implied by a simple and empirically attractive two-country affine term structure model with global and local factors. We also show that the forecasting power of the model compares favorably to the random walk model of exchange rates, considered as benchmark in the literature.

Suggested Citation

  • Efthymios Argyropoulos & Nikolaos Elias & Dimitris Smyrnakis & Elias Tzavalis, 2021. "Can country-specific interest rate factors explain the forward premium anomaly?," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 45(2), pages 252-269, April.
    • Handle: RePEc:spr:jecfin:v:45:y:2021:i:2:d:10.1007_s12197-020-09509-5
    DOI: 10.1007/s12197-020-09509-5
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    References listed on IDEAS

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    Cited by:

    1. Elias, Nikolaos & Smyrnakis, Dimitris & Tzavalis, Elias, 2022. "Predicting future exchange rate changes based on interest rates and holding-period returns differentials net of the forward risk premium effects," International Review of Economics & Finance, Elsevier, vol. 79(C), pages 694-715.

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    More about this item

    Keywords

    UIRP; Two-country affine term structure model; Forward premium anomaly; Exchange rate forecasting; Expectations hypothesis;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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