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Forecasting Currency Excess Returns: Can the Forward Bias Be Exploited?

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  • Villanueva, O. Miguel

Abstract

The forward bias anomaly implies that currency excess returns are predictable by the forward premium. Yet, recent studies suggest that statistical inference problems may spuriously account for this predictability. This article demonstrates that while currency excess returns are not predictable out of sample using a standard mean square forecast error criterion, the forward premium nonetheless has directional predictability. This directional forecasting accuracy translates into statistically significant profits from trading on the forward bias anomaly.

Suggested Citation

  • Villanueva, O. Miguel, 2007. "Forecasting Currency Excess Returns: Can the Forward Bias Be Exploited?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(04), pages 963-990, December.
  • Handle: RePEc:cup:jfinqa:v:42:y:2007:i:04:p:963-990_00
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    Cited by:

    1. Hochradl, Markus & Wagner, Christian, 2010. "Trading the forward bias: Are there limits to speculation?," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 423-441, April.
    2. Egbers, Tom & Swinkels, Laurens, 2015. "Can implied volatility predict returns on the currency carry trade?," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 14-26.
    3. Darvas, Zsolt, 2009. "Leveraged carry trade portfolios," Journal of Banking & Finance, Elsevier, vol. 33(5), pages 944-957, May.
    4. Wagner, Christian, 2012. "Risk-premia, carry-trade dynamics, and economic value of currency speculation," Journal of International Money and Finance, Elsevier, vol. 31(5), pages 1195-1219.
    5. Baillie, Richard T. & Chang, Sanders S., 2011. "Carry trades, momentum trading and the forward premium anomaly," Journal of Financial Markets, Elsevier, vol. 14(3), pages 441-464, August.
    6. Orlov, Vitaly & Äijö, Janne, 2015. "Benefits of wavelet-based carry trade diversification," Research in International Business and Finance, Elsevier, pages 17-32.
    7. Christian Wagner, 2008. "Risk-Premia, Carry-Trade Dynamics, and Speculative Efficiency of Currency Markets," Working Papers 143, Oesterreichische Nationalbank (Austrian Central Bank).
    8. Ali Shehadeh & Peter Erdos & Youwei Li & Michael Moore, 2016. "US Dollar Carry Trades in the Era of "Cheap Money"," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 66(5), pages 374-404, October.
    9. Bai, Shuming & Mollick, Andre Varella, 2010. "Currency crisis and the forward discount bias: Evidence from emerging economies under breaks," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(5), pages 556-574, December.
    10. Balvers, Ronald J. & Klein, Alina F., 2014. "Currency risk premia and uncovered interest parity in the International CAPM," Journal of International Money and Finance, Elsevier, vol. 41(C), pages 214-230.

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