Predicting Currency Returns: Taking Cues from Economic Theory

59 Pages Posted: 20 Jun 2018 Last revised: 20 Apr 2019

See all articles by Doron Avramov

Doron Avramov

Interdisciplinary Center (IDC) Herzliyah

Yan Xu

HKU, Faculty of Business and Economics

Date Written: April 9, 2019

Abstract

This paper motivates a novel currency-return predictor, the lagged foreign interest rate. This variable is the dividend-to-price equivalent in currency markets and its forecasting ability is incremental to carry and other established predictors. Currency-return predictability is primarily attributable to time-series (rather than cross-sectional) variation in the foreign interest rate, as prescribed by economic theory. Then, forward premium regressions that exploit return predictability consistently generate positive slope estimates, a step forward towards resolving uncovered interest rate parity. From a U.S. investor's perspective, currency strategies that condition on the lagged foreign interest rate deliver significant alphas and outperform the dollar carry-trade strategy.

Keywords: Loglinearization, Currency Market Return, Forward Premium Puzzle, trading strategy

JEL Classification: G12, F31

Suggested Citation

Avramov, Doron and Xu, Yan, Predicting Currency Returns: Taking Cues from Economic Theory (April 9, 2019). Available at SSRN: https://ssrn.com/abstract=3197288 or http://dx.doi.org/10.2139/ssrn.3197288

Doron Avramov

Interdisciplinary Center (IDC) Herzliyah ( email )

P.O. Box 167
Herzliya, 46150
Israel

Yan Xu (Contact Author)

HKU, Faculty of Business and Economics ( email )

Pok Fu Lam Road
Hong Kong
Hong Kong

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