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Can country-specific interest rate factors explain the forward premium anomaly?

Efthymios Argyropoulos, Nikolaos Elias (), Dimitris Smyrnakis and Elias Tzavalis ()
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Efthymios Argyropoulos: Athens University of Economics & Business
Nikolaos Elias: Athens University of Economics & Business

Journal of Economics and Finance, 2021, vol. 45, issue 2, No 4, 252-269

Abstract: Abstract The forward premium anomaly refers to the fact that changes in spot exchange rates are negatively related to interest rate differentials between home and foreign countries, which is contrary to the predictions of the uncovered interest rate parity (UIRP). We propose a regression model of the interest rate differentials across countries (known as carry trade) adjusted for a time-varying exchange rate risk premium which can explain the anomaly and provide forecasts of exchange rate changes in accordance to the theory. The proposed model is based on estimates of the exchange rate risk premium implied by a simple and empirically attractive two-country affine term structure model with global and local factors. We also show that the forecasting power of the model compares favorably to the random walk model of exchange rates, considered as benchmark in the literature.

Keywords: UIRP; Two-country affine term structure model; Forward premium anomaly; Exchange rate forecasting; Expectations hypothesis (search for similar items in EconPapers)
JEL-codes: E43 F31 G14 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1007/s12197-020-09509-5

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