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

Efthymios Argyropoulos, Nikolaos Elias (), Dimitris Smyrnakis and Elias Tzavalis
Additional contact information
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
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://link.springer.com/10.1007/s12197-020-09509-5 Abstract (text/html)
Access to the full text of the articles in this series is restricted.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:spr:jecfin:v:45:y:2021:i:2:d:10.1007_s12197-020-09509-5

Ordering information: This journal article can be ordered from
http://www.springer. ... cs/journal/12197/PS2

DOI: 10.1007/s12197-020-09509-5

Access Statistics for this article

Journal of Economics and Finance is currently edited by James Payne

More articles in Journal of Economics and Finance from Springer, Academy of Economics and Finance Contact information at EDIRC.
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().