The Term Structure of Exchange Rate Predictability: Commonality, Scapegoat, and Disagreement

Abstract

In this paper we study the exchange rate predictability across a range of investment horizons by return decomposition into forward premium component and carry trade risk premium component, for which we propose a term structure model to capture exchange rate dynamics with a broad set of predictors meanwhile handle both parameter and model uncertainties. We demonstrate the time-varying term-structural and model disagreement effects of exchange rate determinants as well as the projections of predictive information over the term structure. We also utilize the time-variation in the probability weighting from dynamic model averaging to identify the scapegoat drivers of customer order flows, which are also informative about the term structure of carry trade risk premia. Our findings reveal that heterogeneous agents learn to forecast exchange rates and switch trading rules over time, resulting in the dynamic country-specific and global exposures of exchange rates to short-run non-fundamental risk and long-run business cycle risk. Hedging pressure and liquidity are identified to contain predictive information that is common to a range of forecasting horizons. Policy-related predictors are important for short-run forecasts up to 3 months while crash risk indicators matter for long-run forecasts from 9 months to 12 months. We further comprehensively evaluate both statistical and economic significance of the model allowing for a full spectrum of currency investment management, and find that the model generates substantial performance fees of 6.5% per annum.

Keywords: Exchange Rate Forecasting, Carry Trade Risk Premia, Term Structure Factors, Scapegoat Variables, Model Disagreement, Customer Order Flows, Disconnect Puzzle