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

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  • Yu-chin Chen
  • Kwok Ping Tsang

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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Bibliographic Info

Paper provided by Virginia Polytechnic Institute and State University, Department of Economics in its series Working Papers with number e07-15.

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Length: 32 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:vpi:wpaper:e07-15

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Keywords: Exchange Rate Forecasting; 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, 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.
  2. Yu-chin Chen & Kwok Ping Tsang, 2009. "A Macro-Finance Approach to Exchange Rate Determination," Working Papers UWEC-2009-24-R, University of Washington, Department of Economics, revised May 2010.
  3. Travis J. Berge, 2011. "Forecasting disconnected exchange rates," Research Working Paper RWP 11-12, Federal Reserve Bank of Kansas City.
  4. Yu-chin Chen & Kwok Ping Tsang & Wen Jen Tsay, 2010. "Home Bias in Currency Forecasts," Working Papers 272010, Hong Kong Institute for Monetary Research.
  5. Travis J. Berge & Òscar Jordà & Alan M. Taylor, 2010. "Currency Carry Trades," NBER Working Papers 16491, National Bureau of Economic Research, Inc.
    • 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.

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