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The term structure of exchange rate predictability: Commonality, scapegoat, and disagreement

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  • Cao, Shuo
  • Huang, Huichou
  • Liu, Ruirui
  • MacDonald, Ronald

Abstract

In this paper, we study the exchange rate predictability across a range of investment horizons by proposing a generalized (term structure) model to capture the dynamics between the risk premium component of exchange rates and a broad set of variables meanwhile handle both parameter and model uncertainty. We also demonstrate the projections of common predictable information over the term structure, and existence of time-varying term-structural effect and model disagreement effect of exchange rate predictors in FX trading, which in turn validates the practical use of our model. We then utilize the time-variation in the probability weighting to identify the scapegoat drivers of customer order flows. We further comprehensively evaluate both statistical and economic significance of the model allowing for a full spectrum of currency investment management, and find that the model generates substantial performance fees of 6.5% per annum.

Suggested Citation

  • Cao, Shuo & Huang, Huichou & Liu, Ruirui & MacDonald, Ronald, 2019. "The term structure of exchange rate predictability: Commonality, scapegoat, and disagreement," Journal of International Money and Finance, Elsevier, vol. 95(C), pages 379-401.
    • Handle: RePEc:eee:jimfin:v:95:y:2019:i:c:p:379-401
    DOI: 10.1016/j.jimonfin.2018.03.013
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    Cited by:

    1. Cheung, Yin-Wong & Wang, Wenhao, 2022. "Uncovered interest rate parity redux: Non-uniform effects," Journal of Empirical Finance, Elsevier, vol. 67(C), pages 133-151.
    2. Narayan, Paresh Kumar & Bannigidadmath, Deepa & Narayan, Seema, 2021. "How much does economic news influence bilateral exchange rates?," Journal of International Money and Finance, Elsevier, vol. 115(C).
    3. de Souza Vasconcelos, Camila & Hadad Júnior, Eli, 2023. "Forecasting exchange rate: A bibliometric and content analysis," International Review of Economics & Finance, Elsevier, vol. 83(C), pages 607-628.
    4. Eric Hillebrand & Jakob Mikkelsen & Lars Spreng & Giovanni Urga, 2020. "Exchange Rates and Macroeconomic Fundamentals: Evidence of Instabilities from Time-Varying Factor Loadings," CREATES Research Papers 2020-19, Department of Economics and Business Economics, Aarhus University.

    More about this item

    Keywords

    Exchange rate forecasting; Disconnect puzzle; Carry trade risk premia; Term structure factors; Scapegoat variables; Model disagreement; Customer order flows;
    All these keywords.

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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