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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 and Hong Kong Institute for Monetary Research)

  • Kwok Ping Tsang

    (Virginia Tech and Hong Kong Institute for Monetary Research)

Abstract

This paper uses information contained in the cross-country yield curves to test the asset-pricing approach to exchange rate determination, which models the nominal exchange rate as the discounted present value of its expected future fundamentals. Since the term structure of interest rates embodies information about future economic activity such as GDP growth and inflation, we extract the Nelson-Siegel (1987) factors of relative level, slope, and curvature from cross-country yield differences to proxy expected movements in future exchange rate fundamentals. Using monthly data between 1985-2005 for the United Kingdom, Canada, Japan and the US, we show that the yield curve factors predict bilateral exchange rate movements and excess currency returns one month to two years ahead. They also outperform the random walk in forecasting short-term exchange rate returns out of sample. Our findings have intuitive economic interpretations and offer an explanation to the uncovered interest parity puzzle.

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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 292010.

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Length: 40 pages
Date of creation: Nov 2010
Date of revision:
Handle: RePEc:hkm:wpaper:292010

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Keywords: Exchange Rate Forecasting; Term Structure of Interest Rates; Uncovered Interest Parity;

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Citations

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Cited by:
  1. Barbara Rossi, 2013. "Exchange Rate Predictability," Journal of Economic Literature, American Economic Association, vol. 51(4), pages 1063-1119, December.
  2. Travis J. Berge & Òscar Jordà & Alan M. Taylor, 2010. "Currency Carry Trades," NBER Working Papers 16491, National Bureau of Economic Research, Inc.
  3. Travis J. Berge, 2011. "Forecasting disconnected exchange rates," Research Working Paper, Federal Reserve Bank of Kansas City RWP 11-12, Federal Reserve Bank of Kansas City.
  4. Wagner Piazza Gaglianone & Jaqueline Terra Moura Marins, 2014. "Risk Assessment of the Brazilian FX Rate," Working Papers Series, Central Bank of Brazil, Research Department 344, Central Bank of Brazil, Research Department.
  5. Yu-chin Chen & Kwok Ping Tsang & Wen Jen Tsay, 2010. "Home Bias in Currency Forecasts," Working Papers e07-18, Virginia Polytechnic Institute and State University, Department of Economics.
  6. Aysun, Uluc & Lee, Sanglim, 2014. "Can time-varying risk premiums explain the excess returns in the interest rate parity condition?," Emerging Markets Review, Elsevier, Elsevier, vol. 18(C), pages 78-100.
  7. Yu-chin Chen & Kwok Ping Tsang, 2009. "A Macro-Finance Approach to Exchange Rate Determination," Working Papers, University of Washington, Department of Economics UWEC-2009-24-R, University of Washington, Department of Economics, revised May 2010.
  8. 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.
  9. Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.
  10. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2010. "Countercyclical Currency Risk Premia," NBER Working Papers 16427, National Bureau of Economic Research, Inc.

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