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Currency forecast errors at times of low interest rates: evidence from survey data on the Yen/Dollar exchange rate

  • Ronald MacDonald

    ()

    (Adam Smith Business School, University of Glasgow)

  • Jun Nagayasu

    ()

    (Faculty of Engineering, Information and Systems, University of Tsukuba)

Using survey expectations data and Markov-switching models, this paper evaluates the characteristics and evolution of investors’ forecast errors about the yen/dollar exchange rate. Since our model is derived from the uncovered interest rate parity (UIRP) condition and our data cover a period of low interest rates, this study is also related to the forward premium puzzle and the currency carry trade strategy. We obtain the following results. First, with the same forecast horizon, exchange rate forecasts are homogeneous among different industry types, but within the same industry, exchange rate forecasts differ if the forecast time horizon is different. In particular, investors tend to undervalue the future exchange rate for long term forecast horizons; however, in the short run they tend to overvalue the future exchange rate. Second, while forecast errors are found to be partly driven by interest rate spreads, evidence against the UIRP is provided regardless of the forecasting time horizon; the forward premium puzzle becomes more significant in shorter term forecasting errors. Consistent with this finding, our coefficients on interest rate spreads provide indirect evidence of the yen carry trade over only a short term forecast horizon. Furthermore, the carry trade seems to be active when there is a clear indication that the interest rate will be low in the future.

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File URL: http://www.strath.ac.uk/media/departments/economics/researchdiscussionpapers/2013/13-21FINAL.pdf
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Paper provided by University of Strathclyde Business School, Department of Economics in its series Working Papers with number 1321.

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Length: 35 pages
Date of creation: Oct 2013
Date of revision:
Publication status: Published
Handle: RePEc:str:wpaper:1321
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