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Yield Curve Predictors of Foreign Exchange Returns

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper titled “Yield Curve Predictors of Foreign Exchange Returns” by Andrew Ang and Joseph Chen presents an illuminating examination of the potential of yield curve predictors to forecast foreign exchange risk premiums within a no-arbitrage framework.

While the disparity in short rates across countries, also known as carry, is the most commonly utilized interest rate predictor, the study accentuates that the short rate is merely one of several factors influencing domestic yield curves.

Notably, the research reveals that, in addition to interest rate levels, various other yield curve predictors hold substantial potential to predict the cross-section of currency returns.

Furthermore, the study underscores that changes in interest rates and term spreads exhibit significant predictability of excess foreign exchange returns, while concurrently demonstrating low skewness risk and minimal correlation with carry returns.

Impressively, predictability from these yield curve variables has been observed to endure for up to 12 months and has exhibited robustness when controlling for other predictors of currency returns.

This comprehensive investigation furnishes valuable insights into the potential of yield curve predictors in forecasting foreign exchange risk premiums, enriching our comprehension of the intricate dynamics underlying currency returns.

Abstract Of Paper

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 in addition to interest rate levels other yield curve predictors have significant ability to forecast the cross section of currency returns. In particular, changes of interest rates and term spreads significantly predict excess foreign exchange returns, exhibit low skewness risk, and are lowly correlated 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.

Original paper – Download PDF

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Author

Andrew Ang
BlackRock, Inc

Joseph Chen
University of California, Davis – Graduate School of Management

Conclusion

In conclusion, the research paper “Yield Curve Predictors of Foreign Exchange Returns” authored by Andrew Ang and Joseph Chen provides a thought-provoking exploration of the forecast potential of yield curve predictors in estimating foreign exchange risk premiums within a no-arbitrage framework.

The study accentuates that, beyond interest rate levels, other yield curve predictors hold notable predictive power in forecasting the cross-section of currency returns. Notably, changes in interest rates and term spreads have demonstrated significant predictability of excess foreign exchange returns, characterized by low skewness risk and minimal correlation with carry returns.

The research has robustly upheld the persistence of predictability from these yield curve variables for up to 12 months and has demonstrated resilience in the presence of control for other predictors of currency returns.

This insightful analysis enhances our understanding of the intricacies underlying currency returns, shedding light on the potential of yield curve predictors to appraise foreign exchange risk premiums and enriching the body of knowledge in this domain.

Related Reading:

A Multi-Strategy Approach to Trading Foreign Exchange Futures

Carry Trades and Global Foreign Exchange Volatility

FAQ

Q1: What is the main focus of the research paper “Yield Curve Predictors of Foreign Exchange Returns” by Andrew Ang and Joseph Chen?

A1: The main focus of the research paper is to examine the potential of yield curve predictors to forecast foreign exchange risk premiums within a no-arbitrage framework. The study investigates various factors beyond interest rate levels that may influence domestic yield curves and have the ability to predict the cross-section of currency returns.

Q2: What does the study emphasize regarding interest rate predictors in the context of foreign exchange risk premiums?

A2: While the most commonly used interest rate predictor is the difference in short rates across countries, known as carry, the study emphasizes that the short rate is only one of many factors influencing domestic yield curves. The research explores other yield curve predictors that could contribute to forecasting foreign exchange risk premiums.

Q3: What are some key findings regarding the predictability of currency returns from yield curve variables?

A3: The study finds that changes in interest rates and term spreads exhibit significant predictability of excess foreign exchange returns. Importantly, these variables demonstrate low skewness risk and minimal correlation with carry returns. The predictability from these yield curve variables has been observed to persist for up to 12 months and remains robust when controlling for other predictors of currency returns.

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