This paper focuses on two actively studied inefficiencies in financial markets: the forward premium bias in foreign exchange markets (see, for example, Hansen and Hodrick 1980, Fama 1984, Bansal and Dahlquist 2000, etc.) and the empirical finding that the time expectations theory performs relatively poorly in describing the average shape of yield curves (for a list of papers see, for example, Backus et al. 1998, p 1). The goal of the article is to test whether these two inefficiencies can still offer the possibilities of earning positive and stable excess return for investors. For that purpose, first two very simple trading strategies are tested based on the abovementioned inefficiencies: buying the currencies of the countries with higher short-term interest rates against the currencies of the countries with lower short-term interest rates (i.e. simple FX carry-strategy) and holding long-only positions in longerterm interest rate futures. The results show that the two studied risk premiums are still present in the markets and enable investors to earn excess returns even with simple strategies. Additional tests show that the performance of these simple strategies can be further improved by the inclusion of a risk factor in the foreign exchange carry-strategy and by the addition of monetary policy direction and yield curve steepness filters in the long-only strategy in interest rate futures.
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Find related papers by JEL classification: E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
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