Andrew Ang

Yield Curve Predictors of Foreign Exchange Returns

Coauthor(s): Joseph Chen.

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Abstract:
In a no-arbitrage framework, any variable that affects the pricing of the domestic yield curve has the potential to predict foreign exchange risk premiums. The most widely used interest rate predictor is the difference in short rates across countries, known as carry, but the short rate is only one of many factors affecting domestic yield curves. We find that other yield curve predictors like changes of interest rates and term spreads significantly predict excess foreign exchange returns. Currency portfolio returns based on changes in interest rates and term spreads exhibit low skewness risk and have low correlation with carry returns. Predictability from these yield curve variables persists up to 12 months and is robust to controlling for other predictors of currency returns.

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