Exchange Rates and Interest Rates: Can Term Structure Models Explain Currency Movements?
Posted: 22 Jan 2005
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
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