The Term Structure of Exchange Rate Predictability: Commonality, Scapegoat, and Disagreement

2016 Society for Financial Econometrics Annual Conference; Hong Kong, China.

28th Australasian Finance and Banking Conference

79 Pages Posted: 11 Jul 2015 Last revised: 28 Jul 2016

Multiple version iconThere are 2 versions of this paper

Date Written: April 23, 2015

Abstract

In this paper we study the exchange rate predictability across a range of investment horizons by return decomposition into forward premium component and carry trade risk premium component, for which we propose a term structure model to capture exchange rate dynamics with a broad set of predictors meanwhile handle both parameter and model uncertainties. We demonstrate the time-varying term-structural and model disagreement effects of exchange rate determinants as well as the projections of predictive information over the term structure. We also utilize the time-variation in the probability weighting from dynamic model averaging to identify the scapegoat drivers of customer order flows, which are also informative about the term structure of carry trade risk premia. Our findings reveal that heterogeneous agents learn to forecast exchange rates and switch trading rules over time, resulting in the dynamic country-specific and global exposures of exchange rates to short-run non-fundamental risk and long-run business cycle risk. Hedging pressure and liquidity are identified to contain predictive information that is common to a range of forecasting horizons. Policy-related predictors are important for short-run forecasts up to 3 months while crash risk indicators matter for long-run forecasts from 9 months to 12 months. We further comprehensively evaluate both statistical and economic significance of the model allowing for a full spectrum of currency investment management, and find that the model generates substantial performance fees of 6.5% per annum.

Keywords: Exchange Rate Forecasting, Carry Trade Risk Premia, Term Structure Factors, Dynamic (Bayesian) Model Averaging, Model Disagreement, Scapegoat Variables, Customer Order Flows

JEL Classification: C52, E43, F31, F37, G11

Suggested Citation

Huang, Huichou, The Term Structure of Exchange Rate Predictability: Commonality, Scapegoat, and Disagreement (April 23, 2015). 2016 Society for Financial Econometrics Annual Conference; Hong Kong, China.; 28th Australasian Finance and Banking Conference. Available at SSRN: https://ssrn.com/abstract=2629345 or http://dx.doi.org/10.2139/ssrn.2629345

Huichou Huang (Contact Author)

City University of Hong Kong

Global Research Unit (GRU), College of Business
Department of Economics & Finanace
Hong Kong
China

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
142
Abstract Views
988
rank
116,096
PlumX Metrics