Predicting Currency Returns: New Evidence on the Forward Premium Puzzle and the Dollar-trade Strategy
55 Pages Posted: 20 Jun 2018 Last revised: 11 Feb 2019
Date Written: February 9, 2019
This paper motivates a new currency return predictor, the lagged foreign interest rate. The predictor emerges from log-linearizing the un-hedged foreign investment return, and is the dividend-to-price equivalent in currency markets. The evidence shows that the foreign rate reliably predicts future returns while its predictive power goes well beyond carry. Then, forward premium regressions that exploit the model-implied predictability consistently generate positive slope estimates, a step forward towards resolving the uncovered interest rate parity puzzle. From a U.S. investor's perspective, currency strategies that condition on the lagged foreign interest rate deliver significant alphas with respect to currency factors and they outperform the dollar carry trade.
Keywords: Loglinearization, Currency Market Return, Forward Premium Puzzle, trading strategy
JEL Classification: G12, F31
Suggested Citation: Suggested Citation