The term structure of exchange rate predictability: Commonality, scapegoat, and disagreement

Abstract

In this paper we study the exchange rate predictability across a range of investment horizons by proposing a generalized (term structure) model to capture the risk premium component of exchange rates with a broad set of variables meanwhile handle both parameter and model uncertainty. We demonstrate the existence of time-varying term-structural effect and model disagreement effect of exchange rate predictors as well as the projections of predictive information over the term structure. We further utilize the time-variation in the probability weighting to identify the scapegoat drivers of customer order flows. Our findings suggest that heterogeneous agents learn to forecast exchange rates and switch trading rules over time, resulting in the dynamic country-specific and global exposures of exchange rates to shortrun non-fundamental risk and long-run business cycle risk. Hedging pressure and liquidity are identified to contain predictive information that is common to a range of forecasting horizons. Policy-related predictors are important for short-run forecasts up to 3 months while crash risk indicators matter for long-run forecasts from 9 months to 12 months. We further comprehensively evaluate both statistical and economic significance of the model allowing for a full spectrum of currency investment management, and find that the model generates substantial performance fees of 6.5% per annum. The outperformance is mainly due to (i) the relaxing of restrictions imposed on structural parameters via model generalization, and (ii) the use of factor structure to extract common useful information from noisy data and reduce estimation errors.

Exploring Carry Trade and Exchange Rate toward Sustainable Financial Resources: An application of the Artificial Intelligence UKF Method

“…By comparing a portfolio based on expectations with trend and carry trade portfolios, it is found that carry trade strategies become less profitable with low interest rate differentials and note that the time-varying characteristic of monetary policy affects expectations [57]. The investigations show that currency carry trade risk premia and the linkage between carry trade risk premia and customer order flow could explain most of the term structure of exchange rate predictability [12]. Consistent with the literature on nonlinear exchange rate models, the excess returns with carry trading strategies, along with the potential asymmetric dependence between the carry trade and currency return, have been found in the foreign exchange market [58][59][60].…”

“…Higher implementation costs lead to higher volatility and risk, so carry traders will not be active in the market [78]. Only if the carry trade strategy is expected to be profitable will it be implemented, and then the weights of different types of forecasting rules would be the upper parts of Equations (12) and (13). If r d t − r f t is lower than the threshold τ, then the carry trade strategy will not yield substantial profit, and carry traders will disappear from the market.…”

“…Carry traders' activities have been proven to have a significant and increasing influence on the exchange rate [9]. Studies have examined various characteristics of carry traders' activities in the foreign exchange market, such as the ability to explain the forward premium and currency funds, factors determining carry traders' profits, the linkage between carry trade risk premia and customer order flow, and the potential asymmetric dependence between carry trade and currency return [10][11][12]. Meanwhile, the heterogeneous agent model for carry traders explains the forward premium puzzle, exchange rate disconnects, deviation of the market-determined exchange rate from the fundamental value, and the microstructure of the foreign exchange market [13][14][15].…”

Does maturity matter? The case of treasury futures volume

“…Capistrán and Timmermann () talk about long‐ and short‐term forecast disagreements in the context of inflation. Cao et al () propose a generalized term structure model for exchange rate predictability across different investment horizons.…”

“…More recently, this line of literature has been growingly rich in emphasizing the term structure of disagreements. To date, the role of disagreement at different maturities has been discussed in the context of federal funds rates and GDP output (Andrade, Crump, Eusepi, & Moench, 2016), inflation (Andrade et al, 2016;Capistrán & Timmermann, 2009), bond yields (Crump, Eusepi, & Moench, 2018), and exchange rates (Cao, Huang, Liu, & MacDonald, 2018). Evident from these studies, disagreements in the short-and long-term segments of a market are economically different.…”