Monetary Policy and Exchange Rate Returns: Time-Varying Risk Regimes

85 Pages Posted: 17 Mar 2019 Last revised: 26 Apr 2019

See all articles by Charles W. Calomiris

Charles W. Calomiris

Columbia University - Columbia Business School; National Bureau of Economic Research (NBER)

Harry Mamaysky

Columbia University - Columbia Business School

Multiple version iconThere are 2 versions of this paper

Date Written: April 24, 2019

Abstract

We develop an empirical model of exchange rate returns, applied separately to samples of developed (DM) and developing (EM) economies’ currencies against the dollar. Monetary policy stance of the global central banks, measured via a natural-language-based approach, has a large effect on exchange rate returns over the ensuing year, is closely linked to the VIX, and becomes increasingly important in the post-crisis era. We document an important spillover effect: monetary policy of the Bank of England, the Bank of Japan and the ECB is as important as Fed policy in forecasting currency returns against the dollar. In the post-crisis era, a one standard deviation increase in dovishness of all four central banks forecasts a 5.8% (4.0%) one-year excess return of DM (EM) currencies. Furthermore, we find that the relation between a DM country’s interest rate differential relative to the dollar (carry) and the future returns from investing in its currency switches sign from the pre- to the post-crisis subperiod, while for EMs the carry variable is never a significant predictor of returns. The high profit from the carry trade for EM currencies reflects persistent country characteristics likely reflective of risk rather than the interest differential per se. While measures of global monetary policy stance forecast exchange rate returns against the dollar, they do not predict exchange rate returns against other base currencies. Results regarding returns from carry, however, are insensitive to the choice of the base currency. We construct a no-arbitrage pricing model which reconciles many of our empirical findings.

Keywords: exchange rate forecasting, monetary policy, carry trade, natural language processing

JEL Classification: F31, F37, E4, G15

Suggested Citation

Calomiris, Charles W. and Mamaysky, Harry, Monetary Policy and Exchange Rate Returns: Time-Varying Risk Regimes (April 24, 2019). Available at SSRN: https://ssrn.com/abstract=3341004 or http://dx.doi.org/10.2139/ssrn.3341004

Charles W. Calomiris

Columbia University - Columbia Business School ( email )

3022 Broadway
601 Uris, Dept. of Finance & Economics
New York, NY 10027
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212-854-8748 (Phone)
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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

Harry Mamaysky (Contact Author)

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

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