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Journal of Economics and Finance
Erschienen in:

05.07.2020

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

verfasst von: Efthymios Argyropoulos, Nikolaos Elias, Dimitris Smyrnakis, Elias Tzavalis

Erschienen in: Journal of Economics and Finance | Ausgabe 2/2021

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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.
Vorheriger Artikel Six decades of inflation and money demand
Nächster Artikel Public debt and economic growth: panel data evidence for Asian countries

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Fußnoten
1
Alternative theories include the following: peso problems due to missed regime shifts by investors (see Evans and Karen 1995), exchange rate stabilization monetary policy rules smoothing out exchange rate changes (see McCallum 1994), sticky prices yielding time-varying real exchange rate deviations from the PPP (purchasing power parity) (see, e.g., see Meese and Rogoff 1988, and more recently Boudoukh et al. 2016) and measurement errors combined with small magnitudes of interest rate differentials, see, e.g., Lothian and Wu (2011).
 
2
This assumption is also consistent with affine term structure models assuming that three factors can explain the total term structure variation (see, e.g., Dai and Singleton 2002, or more recently Argyropoulos and Tzavalis 2015).
 
3
See Dai and Singleton (2002).
 
4
Similar relationships to Eq. 10 have been derived by Backus et al. (2001) and Ang and Chen (2010) based on stochastic discount factor approach in the discrete-time framework.
 
5
Note that the common factor structure of x1t and x2t across countries allows us to retrieve local factors \(x_{3t}^{(j)}\) based on the spreads of interest rates \(R_{t}^{(h)}(\tau )-R_{t}^{(f)}(\tau )\), for τ = {τ1,τ2}, by inverting the following relationships:
$$ \begin{array}{@{}rcl@{}} R_{t}^{(h)}(\tau_{1})-R_{t}^{(f)}(\tau_{1})&=&A^{(h)}(\tau_{1})-A^{(f)}(\tau_{1})+D_{3}^{(h)}(\tau_{1})x_{3t}^{(h)}-D_{3}^{(f)}(\tau_{1})x_{3t}^{(f)} \\ R_{t}^{(h)}(\tau_{2})-R_{t}^{(f)}(\tau_{2})&=&A^{(h)}(\tau_{2})-A^{(f)}(\tau_{2})+D_{3}^{(h)}(\tau_{2})x_{3t}^{(h)}-D_{3}^{(f)}(\tau_{2})x_{3t}^{(f)} \end{array} $$
Then, given \(x_{3t}^{(h)}\) and \(x_{3t}^{(f)}\), we can retrieve x1t and x2t by also inverting (6), for τ1 and τ2.
 
6
For Germany, we have used the euro conversion rate of the Deutsche Mark (DM) (i.e., 1.95583) to participate in the EMS to calculate the series of the currency rate of this country with respect to USD after the introduction of Euro as the single currency in 1999. See also Diez de los Rios and Sentana (2011).
 
7
Note that Eurocurrency deposits are essentially zero-coupon bonds whose payoffs at maturity are the principal plus the interest payment. Eurocurrency deposit rates are used in many studies testing the predictions of the UIRP (see, e.g., Olmo and Pilbeam2011).
 
8
Note that ℘t(τ) constitutes a good proxy of the exchange rate risk premium implied by interest rate differential \(R_{t}^{(h)}(1)-R_{t}^{(f)}(1)\), for a small maturity τ and interval of time. This regression model corresponds to Eq. 9 - see Ahn (2004), and it is in the spirit of the regression models of Tzavalis (2003), and Argyropoulos and Tzavalis (2019) adjusting the term spread of interest rates for risk premium effects in order to forecast future changes in short-term interest rates or inflation rate changes, respectively.
 
9
This method has been suggested in the term structure of interest rates literature to capture the effects of the risk premium on the term spread in forecasting future short-term interest rates by Driffill et al. (1997).
 
10
Note that, for models M1 and M2, the DM test statistic is based on the forecast loss function \(d_{t+j}=\left (u_{t+j}^{(M1)}\right )^{2}-\left (u_{t+j}^{(M2)}\right )^{2}\). Given dt+j, DM is defined as \(DM=\left (\frac {1}{T-T_{0}}{\sum }_{j=T_{0}+1}^{T}d_{t+j}\right ) \hat {\sigma _{d}}^{1/2}\), where T0 is the initial, in-sample window of the sample and \(\hat {\sigma _{d}}\) is the long-run variance of dt+j, which can be consistently estimated based on Newey and West (1987) estimator.
 
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Metadaten
Titel
Can country-specific interest rate factors explain the forward premium anomaly?
verfasst von
Efthymios Argyropoulos
Nikolaos Elias
Dimitris Smyrnakis
Elias Tzavalis
Publikationsdatum
05.07.2020
Verlag
Springer US
Erschienen in
Journal of Economics and Finance / Ausgabe 2/2021
Print ISSN: 1055-0925
Elektronische ISSN: 1938-9744
DOI
https://doi.org/10.1007/s12197-020-09509-5

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