Predicting Currency Returns and Exchange Rate Fluctuations

67 Pages Posted: 20 Jun 2018 Last revised: 1 Oct 2019

See all articles by Doron Avramov

Doron Avramov

Interdisciplinary Center (IDC) Herzliyah

Yan Xu

HKU, Faculty of Business and Economics

Date Written: Sep 9, 2019

Abstract

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

Avramov, Doron and Xu, Yan, Predicting Currency Returns and Exchange Rate Fluctuations (Sep 9, 2019). Available at SSRN: https://ssrn.com/abstract=3197288 or http://dx.doi.org/10.2139/ssrn.3197288

Doron Avramov

Interdisciplinary Center (IDC) Herzliyah ( email )

P.O. Box 167
Herzliya, 46150
Israel

Yan Xu (Contact Author)

HKU, Faculty of Business and Economics ( email )

Pok Fu Lam Road
Hong Kong
Hong Kong

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