No abstract

In this paper, we revisit the predictive content of interest rates for daily exchange rate returns. The novelty of our approach is to take into account dependencies of higher orders by allowing for a time-varying asymmetry in the distribution of exchange rates. Using data on USD/EUR currency pair over the period 1999-2019, we find the dynamic asymmetry component to be significant and driven by interest rate differentials, but also by general uncertainty and past unexpected shocks. In line with recent currency crash theories, our study suggests that the larger the difference between interest rates, the more likely the high yield currency is to appreciate but also to experience currency crashes. To assess the economic significance of our results, we introduce a directional forecasting approach derived from our model. We show that a trading rule based on these forecasts provides better in-sample and out-of-sample economic performance compared to benchmark models.

One of the most important advantages of an inflation target is that it helps to reduce uncertainty about future inflation. However, this confidence may be undermined if actual inflation continuously deviates from the target level. We examine how inflation uncertainty relates to the presence of an inflation target and deviations of inflation from the targeted level. Inflation uncertainty is quantified by means of an unobserved components stochastic volatility model that allows to distinguish between permanent and transitory inflation uncertainty. While long-term inflation appears largely stable in most economies, the short-term inflation uncertainty is found to be time-varying. Most notably, short-term inflation uncertainty is high if inflation rates are below the target level. This is particularly relevant for economies which are currently confronted with the presence of persistently low-inflation rates. Our findings suggest that announcing higher inflation targets as it is currently discussed may be costly in terms of provoking higher inflation uncertainty.

We study the link between the volatility of exchange rates and interest rate differentials (IRD), motivated by the importance of currency carry trade activities in exchange rate dynamics. We examine this link by means of an extended stochastic volatility model, for which we detail an efficient estimation strategy based on Gaussian mixture sampling and a linearization of the volatility process. We apply this approach to six currency pairs over the period from January 1999 to December 2017. Our results suggest that changes in IRD affect volatility differently for low and high-interest-rate currencies. The volatility reacts strongly and positively to increases in the low interest rate, an effect consistent with the unwinding of carry trade positions. In contrast, the response to a raise in the high interest rate is negative and substantially smaller. In general, we find that the informational content of the interest rate differentials regarding the volatility of exchange rate is greater during and after the global financial crisis, compared to the pre-crisis period.

We study the link between the volatility of exchange rates and interest rate differentials (IRD), motivated by the importance of currency carry trade activities in exchange rate dynamics. We examine this link by means of an extended stochastic volatility model, for which we detail an efficient estimation strategy based on Gaussian mixture sampling and a linearization of the volatility process. We apply this approach to six currency pairs over the period from January 1999 to December 2017. Our results suggest that changes in IRD affect volatility differently for low and high-interest-rate currencies. The volatility reacts strongly and positively to increases in the low interest rate, an effect consistent with the unwinding of carry trade positions. In contrast, the response to a raise in the high interest rate is negative and substantially smaller. In general, we find that the informational content of the interest rate differentials regarding the volatility of exchange rate is greater during and after the global financial crisis, compared to the pre-crisis period.