Predicting Currency Market Returns through Log-Linearization

44 Pages Posted: 20 Jun 2018 Last revised: 10 Nov 2018

See all articles by Doron Avramov

Doron Avramov

Interdisciplinary Center (IDC) Herzliyah

Yan Xu

HKU, Faculty of Business and Economics

Date Written: November 6, 2018

Abstract

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

Avramov, Doron and Xu, Yan, Predicting Currency Market Returns through Log-Linearization (November 6, 2018). 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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