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What Does the Yield Curve Tell Us About Exchange Rate Predictability?

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Author Info
Yu-chin Chen
Kwok Ping Tsang

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Abstract

This paper uses information contained in the cross-country yield curves to test the asset-pricing approach to exchange rate determination, which models the nominal exchange rate as the discounted present value of its expected future fundamentals. Research on the term structure of interest rates has long argued that the yield curve contains information about future economic activity such as GDP growth and inflation. Bringing this lesson to the international context, we extract the Nelson-Siegel (1987) factors of relative level, slope, and curvature from cross-country yield differences to proxy expected movements in future exchange rate fundamentals. Using monthly data between 1985-2005 for the United Kingdom, Canada, Japan and the US, we show that the yield curve factors indeed can explain and predict bilateral exchange rate movements and excess currency returns one month to two years ahead. Out-of- sample analysis also shows the yield curve factors to outperform a random walk in forecasting short-term exchange rate returns.

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File URL: ftp://repec.econ.vt.edu/Papers/Tsang/CTv4.pdf
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Publisher Info
Paper provided by Virginia Polytechnic Institute and State University, Department of Economics in its series Working Papers with number e07-15.

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Length: 32 pages
Date of creation: 2009
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Handle: RePEc:vpi:wpaper:e07-15

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Keywords: Exchange Rate Forecasting; Term Structure of Interest Rates; Uncovered Interest; Parity;

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