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Currency forecast errors and carry trades at times of low interest rates: Evidence from survey data on the yen/dollar exchange rate

Ronald MacDonald and Jun Nagayasu

Journal of International Money and Finance, 2015, vol. 53, issue C, 1-19

Abstract: Using survey expectations data and a variant of the uncovered interest rate parity (UIRP), this paper evaluates the relationship between interest rates and investors' forecast errors about the yen/dollar exchange rate. This study therefore is related to the forward premium puzzle and the currency carry trade strategy. Using relatively short (i.e., 1 to 6 month-ahead) forecast data, we obtain the following results. First, with the same forecast horizon, exchange rate forecasts are homogeneous among different industry types, but within the same industry, exchange rate forecasts differ if the forecast time horizon is different. Second, while forecast errors are found to be partly driven by interest rate spreads, evidence against the UIRP is provided. Consistent with this finding, our coefficients on interest rate spreads obtained from nonlinear models provide indirect evidence of the yen carry trade. In particular, unlike theoretical predictions, the carry trade is found to be active during financial turmoil and when there is a clear indication that the interest rate will be low in the future.

Keywords: Currency forecast errors; Uncovered interest parity; Forward premium puzzle; Carry trade; Markov-switching model; STAR model (search for similar items in EconPapers)
JEL-codes: F3 (search for similar items in EconPapers)
Date: 2015
References: Add references at CitEc
Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:53:y:2015:i:c:p:1-19

DOI: 10.1016/j.jimonfin.2014.12.011

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