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Can interest rate factors explain exchange rate fluctuations?

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  • Yung, Julieta

Abstract

The level, slope, and curvature of the yield curve reflect time variation in investors’ risk premia and are known predictors of excess bond returns and economic activity. In this paper, I develop a term structure model under complete markets and no arbitrage to relate these interest rate factors to exchange rate fluctuations. The Gaussian properties of the stochastic discount factors imply non-linearities in exchange rate risk premia that are shown to account for up to half of the in-sample variation in one-year currency returns for different country pairs during the 1980s–2015 period. I find that interest rate factors help explain exchange rate fluctuations in and out of sample, particularly at longer horizons, and yield profitable currency portfolios relative to standard carry trade strategies.

Suggested Citation

  • Yung, Julieta, 2021. "Can interest rate factors explain exchange rate fluctuations?," Journal of Empirical Finance, Elsevier, vol. 61(C), pages 34-56.
  • Handle: RePEc:eee:empfin:v:61:y:2021:i:c:p:34-56
    DOI: 10.1016/j.jempfin.2021.01.005
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    3. Stavrakeva, Vania & Tang, Jenny, 2016. "Exchange rates and the yield curve," Working Papers 16-21, Federal Reserve Bank of Boston.
    4. Meldrum, Andrew & Raczko, Marek & Spencer, Peter, 2018. "The information in the joint term structures of bond yields," Bank of England working papers 772, Bank of England.
    5. Adhitya Wardhono & Badara Shofi Dana & M.Abd. Nasir, 2017. "Rethinking the exchange rate disconnect puzzle theory in ASEAN-6," Economic Journal of Emerging Markets, Universitas Islam Indonesia, Department of Economics, vol. 9(1), pages 98-103, April.

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    Keywords

    Term structure model; Risk premium; Interest rate factors; Non-linearities;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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