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Predicting exchange rate cycles utilizing risk factors

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  • Ahmed, Jameel
  • Straetmans, Stefan

Abstract

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.

Suggested Citation

  • Ahmed, Jameel & Straetmans, Stefan, 2015. "Predicting exchange rate cycles utilizing risk factors," Journal of Empirical Finance, Elsevier, vol. 34(C), pages 112-130.
  • Handle: RePEc:eee:empfin:v:34:y:2015:i:c:p:112-130
    DOI: 10.1016/j.jempfin.2015.09.001
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    1. repec:eee:reveco:v:59:y:2019:i:c:p:137-149 is not listed on IDEAS
    2. Baghestani, Hamid & Toledo, Hugo, 2017. "Do analysts' forecasts of term spread differential help predict directional change in exchange rates?," International Review of Economics & Finance, Elsevier, vol. 47(C), pages 62-69.
    3. repec:eee:chieco:v:50:y:2018:i:c:p:187-205 is not listed on IDEAS
    4. repec:mje:mjejnl:v:14:y:2018:i:2:p:7-19 is not listed on IDEAS

    More about this item

    Keywords

    Exchange rate cycles; Bulls and bears; Binary choice models; Carry trade; Currency misalignment; Risk factors;

    JEL classification:

    • C25 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Discrete Regression and Qualitative Choice Models; Discrete Regressors; Proportions; Probabilities
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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