Yield Curve Predictors of Foreign Exchange Returns

47 Pages Posted: 25 Jan 2010 Last revised: 15 Jun 2011

Andrew Ang

BlackRock, Inc

Joseph Chen

University of California, Davis - Graduate School of Management

Date Written: March 13, 2010

Abstract

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.

Keywords: carry trade, cross section of foreign exchange rates, predictability, term structure, uncovered interest rate parity

JEL Classification: E43, F31, F37, G15, G17

Suggested Citation

Ang, Andrew and Chen, Joseph, Yield Curve Predictors of Foreign Exchange Returns (March 13, 2010). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1542342 or http://dx.doi.org/10.2139/ssrn.1542342

Andrew Ang

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

Joseph S. Chen (Contact Author)

University of California, Davis - Graduate School of Management ( email )

One Shields Avenue
Davis, CA 95616
United States
(530) 752-7155 (Phone)
(530) 752-2924 (Fax)

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