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The Quanto Theory of Exchange Rates

Author

Listed:
  • Lukas Kremens
  • Ian Martin

Abstract

We present a new identity that relates expected exchange rate appreciation to a risk-neutral covariance term, and use it to motivate a currency forecasting variable based on the prices of quanto index contracts. We show via panel regressions that the quanto forecast variable is an economically and statistically significant predictor of currency appreciation and of excess returns on currency trades. Out of sample, the quanto variable outperforms predictions based on uncovered interest parity, on purchasing power parity, and on a random walk as a forecaster of differential (dollar-neutral) currency appreciation.

Suggested Citation

  • Lukas Kremens & Ian Martin, 2019. "The Quanto Theory of Exchange Rates," American Economic Review, American Economic Association, vol. 109(3), pages 810-843, March.
    • Handle: RePEc:aea:aecrev:v:109:y:2019:i:3:p:810-43
    Note: DOI: 10.1257/aer.20180019
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    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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