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What Does the Yield Curve Tell Us about Exchange Rate Predictability?

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  • Yu-chin Chen

    (University of Washington)

  • Kwok Ping Tsang

    (Virginia Tech)

Abstract

Since the term structure of interest rates embodies information about future economic activity, we extract relative Nelson-Siegel (1987) factors from cross-country yield curve differences to proxy expected movements in future exchange rate fundamentals. Using monthly data for the United Kingdom, Canada, Japan, and the United States, we show that the yield curve factors predict exchange rate movements and explain excess currency returns one month to two years ahead. Our results provide support for the asset pricing formulation of exchange rate determination and offer an intuitive explanation to the uncovered interest parity puzzle by relating currency risk premiums to inflation and business cycle risks. © 2013 The President and Fellows of Harvard College and the Massachusetts Institute of Technology.

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Bibliographic Info

Article provided by MIT Press in its journal Review of Economics and Statistics.

Volume (Year): 95 (2013)
Issue (Month): 1 (March)
Pages: 185-205

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Handle: RePEc:tpr:restat:v:95:y:2013:i:1:p:185-205

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Keywords: exchange rates; term structure of interest rates; uncovered interest parity;

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References

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Citations

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Cited by:
  1. Leo Krippner, 2009. "A theoretical foundation for the Nelson and Siegel class of yield curve models," Reserve Bank of New Zealand Discussion Paper Series DP2009/10, Reserve Bank of New Zealand.
  2. Yu-chin Chen & Kwok Ping Tsang & Wen Jen Tsay, 2010. "Home Bias in Currency Forecasts," Working Papers 272010, Hong Kong Institute for Monetary Research.
  3. Yu-chin Chen & Kwok Ping Tsang, 2011. "A Macro-Finance Approach to Exchange Rate Determination," Working Papers 012011, Hong Kong Institute for Monetary Research.
  4. Travis Berge & Òscar Jordà & Alan M. Taylor, 2010. "Currency Carry Trades," NBER Chapters, in: NBER International Seminar on Macroeconomics 2010, pages 357-387 National Bureau of Economic Research, Inc.
  5. Barbara Rossi, 2013. "Exchange Rate Predictability," Working Papers 690, Barcelona Graduate School of Economics.
  6. Travis J. Berge, 2011. "Forecasting disconnected exchange rates," Research Working Paper RWP 11-12, Federal Reserve Bank of Kansas City.
  7. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2010. "Countercyclical Currency Risk Premia," NBER Working Papers 16427, National Bureau of Economic Research, Inc.
  8. Aysun, Uluc & Lee, Sanglim, 2014. "Can time-varying risk premiums explain the excess returns in the interest rate parity condition?," Emerging Markets Review, Elsevier, vol. 18(C), pages 78-100.
  9. Wagner Piazza Gaglianone & Jaqueline Terra Moura Marins, 2014. "Risk Assessment of the Brazilian FX Rate," Working Papers Series 344, Central Bank of Brazil, Research Department.
  10. Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.

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