Can Interest Rate Factors Explain Exchange Rate Fluctuations?

This paper explores whether interest-rate risk priced in the yield curve drives foreign exchange movements for different country pairs. Using a dynamic term structure model under no arbitrage and complete markets, currency... [ view full abstract ]

This paper explores whether interest-rate risk priced in the yield curve drives foreign exchange movements for different country pairs. Using a dynamic term structure model under no arbitrage and complete markets, currency returns are modeled as the ratio of two countries’ log stochastic discount factors. The implied risk premium establishes a non-linear relationship between interest rates and exchange rates that accounts for the failure of uncovered interest parity and compensates investors for the possible depreciation of the domestic currency. Interest rate factors explain about half of one-year exchange rate fluctuations for different countries during the 1980s-2016 period, suggesting that yield curves contain relevant information on exchange rate dynamics, and that this non-linear relationship is consistent with investors’ behavior.