Yield Curve Predictors of Foreign Exchange Returns
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
University of California, Davis - Graduate School of Management
March 13, 2010
AFA 2011 Denver Meetings Paper
In a no-arbitrage framework, any variable that affects the pricing of the domestic yield curve has the potential to predict foreign exchange risk premiums. The most widely used interest rate predictor is the difference in short rates across countries, known as carry, but the short rate is only one of many factors affecting domestic yield curves. We ﬁnd that in addition to interest rate levels other yield curve predictors have signiﬁcant ability to forecast the cross section of currency returns. In particular, changes of interest rates and term spreads signiﬁcantly predict excess foreign exchange returns, exhibit low skewness risk, and are lowly correlated with carry returns. Predictability from these yield curve variables persists up to 12 months and is robust to controlling for other predictors of currency returns.
Number of Pages in PDF File: 47
Keywords: carry trade, cross section of foreign exchange rates, predictability, term structure, uncovered interest rate parity
JEL Classification: E43, F31, F37, G15, G17working papers series
Date posted: January 25, 2010 ; Last revised: June 15, 2011
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