Predicting Currency Market Returns through Log-Linearization
44 Pages Posted: 20 Jun 2018 Last revised: 10 Nov 2018
Date Written: November 6, 2018
This paper motivates a new currency return predictor, the lagged foreign interest rate. This variable emerges from log-linearizing the currency return, just like the dividend-to-price ratio predicts equity return. Employing a universe of 25 economies, we show that the proposed variable reliably predicts future currency return for investment horizons that range from one to twelve months. We then employ the expected value of exchange depreciation rate, recovered from the predicted currency return, as the dependent variable in forward premium regressions. Estimated slope coefficients are consistently positive, a step forward toward 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 and outperform dollar carry trade.
Keywords: Loglinearization, Currency Market Return, Forward Premium Puzzle, trading strategy
JEL Classification: G12, F31
Suggested Citation: Suggested Citation