What Does the Yield Curve Tell Us about Exchange Rate Predictability?

Yu-chin Chen and Kwok Ping Tsang
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Yu-chin Chen: University of Washington

The Review of Economics and Statistics, 2013, vol. 95, issue 1, 185-205

Abstract: Since the term structure of interest rates embodies information about future economic activity, we extract relative Nelson-Siegel (1987) factors from cross-country yield curve differences to proxy expected movements in future exchange rate fundamentals. Using monthly data for the United Kingdom, Canada, Japan, and the United States, we show that the yield curve factors predict exchange rate movements and explain excess currency returns one month to two years ahead. Our results provide support for the asset pricing formulation of exchange rate determination and offer an intuitive explanation to the uncovered interest parity puzzle by relating currency risk premiums to inflation and business cycle risks. © 2013 The President and Fellows of Harvard College and the Massachusetts Institute of Technology.

Keywords: exchange rates; term structure of interest rates; uncovered interest parity (search for similar items in EconPapers)
JEL-codes: E43 F31 G12 G15 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (73)

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Working Paper: What Does the Yield Curve Tell Us about Exchange Rate Predictability? (2010)
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