The Term Structure of Exchange Rate Predictability: Commonality, Scapegoat, and Disagreement

Shuo Cao, Huichou Huang (), Ruirui Liu () and Ronald MacDonald
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Huichou Huang: Broad Reach Investment Management
Ruirui Liu: King’s College London

No GRU_2017_013, GRU Working Paper Series from City University of Hong Kong, Department of Economics and Finance, Global Research Unit

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 risk premium component of exchange rates with a broad set of variables meanwhile handle both parameter and model uncertainty. We demonstrate the existence of time-varying term-structural effect and model disagreement effect of exchange rate predictors as well as the projections of predictive information over the term structure. We further utilize the time-variation in the probability weighting to identify the scapegoat drivers of customer order flows. Our findings suggest that heterogeneous agents learn to forecast exchange rates and switch trading rules over time, resulting in the dynamic country-specific and global exposures of exchange rates to short- run non-fundamental risk and long-run business cycle risk. Hedging pressure and liquidity are identified to contain predictive information that is common to a range of forecasting horizons. Policy-related predictors are important for short-run forecasts up to 3 months while crash risk indicators matter for long-run forecasts from 9 months to 12 months. 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. The outperformance is mainly due to (i) the relaxing of restrictions imposed on structural parameters via model generalization, and (ii) the use of factor structure to extract common useful information from noisy data and reduce estimation errors.

Keywords: Exchange Rate Forecasting; Disconnect Puzzle; Carry Trade Risk Premia; Term Structure Factors; Scapegoat Variables; Model Disagreement; Customer Order Flows (search for similar items in EconPapers)
JEL-codes: C52 E43 F31 F37 G11 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2017-07-18
New Economics Papers: this item is included in nep-for and nep-mac
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Published in Journal of International Money and Finance, 22 March 2018

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https://www.cb.cityu.edu.hk/ef/doc/GRU/WPS/GRU%232 ... 0Liu%20MacDonald.pdf (application/pdf)

Related works:
Journal Article: The term structure of exchange rate predictability: Commonality, scapegoat, and disagreement (2019)
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