Monetary Policy and Exchange Rate Returns: Time-Varying Risk Regimes
83 Pages Posted: 1 Apr 2019
Date Written: March 2019
We develop an empirical model of exchange rate returns, applied separately to samples of developed and developing economies’ currencies against the dollar. We incorporate into this model natural-language-based measures of the monetary policy stances of the large global central banks, and show that these become increasingly important in the post-crisis era. We find an important spillover effect from the monetary policy of the Bank of England, the Bank of Japan and the ECB to the exchange rate returns of other currencies against the dollar. Furthermore, we find that the relation between a developed 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 emerging markets the carry variable is never a significant predictor of returns. The high profit from the carry trade for emerging market 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.
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