Predicting Currency Returns and Exchange Rate Fluctuations
67 Pages Posted: 20 Jun 2018 Last revised: 1 Oct 2019
Date Written: Sep 9, 2019
This paper motivates a novel predictor of currency returns and exchange rate changes, the lagged foreign interest rate. This variable is the dividend-to-price analogue in currency markets and its forecasting ability is incremental to established predictors. Currency-return predictability is primarily attributable to time-series (versus cross-sectional) variation in the foreign interest rate. Then, forward premium regressions that exploit exchange rate predictability consistently generate positive slopes for both individual counties and the aggregate. 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