Predicting future exchange rate changes based on interest rates and holding-period returns differentials net of the forward risk premium effects
Dimitris Smyrnakis and
Elias Tzavalis ()
International Review of Economics & Finance, 2022, vol. 79, issue C, 694-715
One of the well-known puzzles in the empirical exchange rate literature is the forward premium anomaly; the interest rates differential between two countries predicts the opposite direction of their future exchange rate changes compared to the predictions of the uncovered interest rate parity (UIRP) under the rational expectations hypothesis (REH). In this paper, we show that the above puzzle can be attributed to the time-variation of the exchange rate risk premium (known as forward risk premium). This premium can also explain the failure of the holding-period returns differential to provide unbiased predictions of the future exchange rate changes. To control for the risk premium effects, in this paper we suggest a new forward premium regression framework adjusting the interest rates differential for these effects which are estimated by a two-country term structure model. We provide evidence that the suggested framework can predict the correct direction of the future exchange rate changes for a number of developed countries with liquid currencies. However, its predictive power is small due to excess volatility of the exchange rate changes.
Keywords: Exchange rate risk premium; Forward premium anomaly; Term structure of interest rates; Holding-period returns; Simultaneous systems of equations; Real exchange rate. (search for similar items in EconPapers)
JEL-codes: E43 F31 G14 (search for similar items in EconPapers)
References: View references in EconPapers View complete reference list from CitEc
Citations: Track citations by RSS feed
Downloads: (external link)
Full text for ScienceDirect subscribers only
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:79:y:2022:i:c:p:694-715
Access Statistics for this article
International Review of Economics & Finance is currently edited by H. Beladi and C. Chen
More articles in International Review of Economics & Finance from Elsevier
Bibliographic data for series maintained by Catherine Liu ().