Exchange Rates and Interest Rates: Can Term Structure Models Explain Currency Movements?

Posted: 22 Jan 2005

See all articles by A. Can Inci

A. Can Inci

Bryant University

Biao Lu

University of Michigan at Ann Arbor

Abstract

We construct an international term structure model that has excellent empirical performance in tracking movements of exchange rates and currency returns. The forward premium puzzle is accounted for, yet the model does not have the undesirable properties found in Backus et al. (J. Finance 56 (2001) 279). Examination of the estimated factor structure indicates that local factors are not important in the US, UK, and German markets. Moreover, we find that term structure factors alone cannot satisfactorily explain exchange rate movements. In other words, exchange rates are also affected by other factors that are not in the interest rate dynamics.

Keywords: Exchange rates, Term structure of interest rates, Model selection

JEL Classification: E43, F31, G12

Suggested Citation

Inci, Ahmet Can and Lu, Biao, Exchange Rates and Interest Rates: Can Term Structure Models Explain Currency Movements?. Available at SSRN: https://ssrn.com/abstract=652164

Ahmet Can Inci (Contact Author)

Bryant University ( email )

1150 Douglas Pike
Smithfield, RI 02917
United States

Biao Lu

University of Michigan at Ann Arbor ( email )

500 S. State Street
Ann Arbor, MI 48109
United States

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