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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

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. Research on the term structure of interest rates has long argued that the yield curve contains information about future economic activity such as GDP growth and inflation. Bringing this lesson to the international context, 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 indeed can explain and predict bilateral exchange rate movements and excess currency returns one month to two years ahead. Out-of-sample analysis also shows the yield curve factors to outperform a random walk in forecasting short-term exchange rate returns.

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Paper provided by University of Washington, Department of Economics in its series Working Papers with number UWEC-2009-04.

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Date of creation: Feb 2009
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Handle: RePEc:udb:wpaper:uwec-2009-04

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Citations

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Cited by:
  1. Yu-chin Chen & Kwok Ping Tsang, 2010. "A Macro-Finance Approach to Exchange Rate Determination," Working Papers e07-19, Virginia Polytechnic Institute and State University, Department of Economics.
  2. 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.
  3. Travis J. Berge & Òscar Jordà & Alan M. Taylor, 2010. "Currency Carry Trades," NBER Working Papers 16491, National Bureau of Economic Research, Inc.
  4. 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.
  5. Barbara Rossi, 2013. "Exchange Rate Predictability," Journal of Economic Literature, American Economic Association, vol. 51(4), pages 1063-1119, December.
  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. Leo Krippner, 2012. "A theoretical foundation for the Nelson and Siegel class of yield curve models," CAMA Working Papers 2012-11, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  8. Lustig, Hanno & Roussanov, Nikolai & Verdelhan, Adrien, 2014. "Countercyclical currency risk premia," Journal of Financial Economics, Elsevier, Elsevier, vol. 111(3), pages 527-553.
  9. 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.
  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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