Predicting Currency Returns: Taking Cues from Economic Theory
59 Pages Posted: 20 Jun 2018 Last revised: 20 Apr 2019
Date Written: April 9, 2019
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: Suggested Citation