Explaining Exchange Rate Movements Using Yield Curves in Emerging Countries

Economic agents and policymakers need to understand the factors that determine the exchange rates in order to make decisions to maximize individual and collective wealth respectively. This paper attempts to explain the movements of major emerging country exchange rates adopting a theory based approach. This approach is based on two major concepts of financial economics, the Uncovered Interest Parity condition and the yield curve. Instead of estimating a UIP regression using some interest rate differential at a specific maturity, we use information from the whole term structure. Using Nelson-Siegel parameters extracted from the yield curve differentials as explanatory variables, we estimate GARCH(1,1) models to predict exchange rate movements of 7 major emerging countries. Our findings indicate that yield curves are useful in explaining exchange rate movements. Rising local interest rates lead to local currency appreciation contrary to the UIP condition. Steeper yield curve causes local currency appreciation in some emerging countries and depreciation in others. Effects of the yield curve parameters are generally stronger at longer horizons implying that UIP does not become valid even in the long run. Finally several robustness checks indicate that these results are robust to data frequency, sample period and yield curve characterization methodology.