Beyond Carry: The Prospective Interest Rate Differential and Currency Excess Returns

Fisher College of Business Working Paper No. 2024-03-003

Charles A. Dice Center Working Paper No. 2024-03

48 Pages Posted: 9 Feb 2024

See all articles by Mike Dong

Mike Dong

UC Riverside

Shingo Goto

University of Rhode Island - College of Business Administration

Kewei Hou

Ohio State University (OSU) - Department of Finance

Yan Xu

HKU, Faculty of Business and Economics

Yuzhao Zhang

Alliance Bernstein

Date Written: January 31, 2024

Abstract

We use a Beveridge-Nelson decomposition to link expected foreign-currency excess returns to the “prospective interest rate differential” – the infinite sum of expected future interest rate differentials. Empirically, we find our prospective interest rate differential is a stronger predictor of currency excess returns than carry, in both portfolio sorts and Fama-MacBeth regressions. A factor based on the prospective interest rate differential is also useful in explaining the returns of a broad set of currency test portfolios.

Keywords: Prospective interest rate differential, Carry, Currency return predictability, Factor models

JEL Classification: E43, F31, G12, G15

Suggested Citation

Dong, Mengmeng and Goto, Shingo and Hou, Kewei and Xu, Yan and Zhang, Yuzhao, Beyond Carry: The Prospective Interest Rate Differential and Currency Excess Returns (January 31, 2024). Fisher College of Business Working Paper No. 2024-03-003, Charles A. Dice Center Working Paper No. 2024-03, Available at SSRN: https://ssrn.com/abstract=4721897 or http://dx.doi.org/10.2139/ssrn.4721897

Mengmeng Dong

UC Riverside ( email )

Riverside, CA CA 92521
United States

HOME PAGE: http://https://mikedong.org/

Shingo Goto

University of Rhode Island - College of Business Administration ( email )

Kingston, RI 02881
United States
4018744318 (Phone)
4018744312 (Fax)

Kewei Hou (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-0552 (Phone)
614-292-2418 (Fax)

Yan Xu

HKU, Faculty of Business and Economics ( email )

Pok Fu Lam Road
Hong Kong
Hong Kong

Yuzhao Zhang

Alliance Bernstein ( email )

1345 6th Ave
New York, NY 10105
United States

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