Predicting exchange rate cycles utilizing risk factors

This paper attempts to predict the cyclical behavior of exchange rates by using five risk factors, viz., violations of uncovered interest rate parity (UIP), relative purchasing power parity (RPPP) and pseudo-parity for equity returns, relative (cross-country) TED spreads and relative term spreads. These factors are found to forecast periods of depreciation or appreciation and subsequent reversals. The estimates based on a dynamic probit model reveal that violations of UIP, RPPP and equity market pseudo-parity exhibit predictive power for currency cycles albeit only at short horizons. The proposed framework can be utilized by policy makers to smoothen the resulting currency misalignment and by investors to form trading strategies and hedge their positions as well as re-balance their carry trade positions.