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

49 Pages Posted: 6 Feb 2009 Last revised: 22 Jul 2011

Yu-Chin Chen

University of Washington - Department of Economics

Kwok Ping Tsang

Virginia Polytechnic Institute & State University

Multiple version iconThere are 2 versions of this paper

Date Written: March 1, 2009

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 UK, Canada, Japan and the US, 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 premia to inflation and business cycle risks.

Keywords: Exchange Rate Forecasting, Term Structure of Interest Rates, Uncovered Interest Parity

JEL Classification: E43, F31, G12, G15

Suggested Citation

Chen, Yu-Chin and Tsang, Kwok Ping, What Does the Yield Curve Tell Us about Exchange Rate Predictability? (March 1, 2009). Review of Economics and Statistics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1338412

Yu-Chin Chen (Contact Author)

University of Washington - Department of Economics ( email )

Box 353330
Seattle, WA 98195-3330
United States
206-543-6197 (Phone)

HOME PAGE: http://faculty.washington.edu/yuchin

Kwok Ping Tsang

Virginia Polytechnic Institute & State University ( email )

Blacksburg, VA 24061
United States

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