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What Does the Yield Curve Tell Us about Exchange Rate Predictability?

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Listed:
  • Yu-chin Chen

    (University of Washington)

  • Kwok Ping Tsang

    (Virginia Tech)

Abstract

Since the term structure of interest rates embodies information about future economic activity, we extract relative Nelson-Siegel (1987) factors from cross-country yield curve differences to proxy expected movements in future exchange rate fundamentals. Using monthly data for the United Kingdom, Canada, Japan, and the United States, we show that the yield curve factors predict exchange rate movements and explain excess currency returns one month to two years ahead. Our results provide support for the asset pricing formulation of exchange rate determination and offer an intuitive explanation to the uncovered interest parity puzzle by relating currency risk premiums to inflation and business cycle risks. © 2013 The President and Fellows of Harvard College and the Massachusetts Institute of Technology.

Suggested Citation

  • Yu-chin Chen & Kwok Ping Tsang, 2013. "What Does the Yield Curve Tell Us about Exchange Rate Predictability?," The Review of Economics and Statistics, MIT Press, vol. 95(1), pages 185-205, March.
    • Handle: RePEc:tpr:restat:v:95:y:2013:i:1:p:185-205
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    More about this item

    Keywords

    exchange rates; term structure of interest rates; uncovered interest parity;
    All these keywords.

    JEL classification:

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