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

See all articles by Doron Avramov

Doron Avramov

Interdisciplinary Center (IDC) Herzliyah

Yan Xu

HKU, Faculty of Business and Economics

Date Written: February 9, 2019

Abstract

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

Avramov, Doron and Xu, Yan, Predicting Currency Returns: New Evidence on the Forward Premium Puzzle and the Dollar-trade Strategy (February 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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