Reference : What Drives Exchange Rates? Reassessing Currency Return Predictability
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Business & economic sciences : Finance
What Drives Exchange Rates? Reassessing Currency Return Predictability
Ferreira Filipe, Sara mailto [University of Luxembourg > Faculty of Law, Economics and Finance (FDEF) > Luxembourg School of Finance (LSF) >]
Maio, Paulo mailto [Hanken School of Economics]
[en] Exchange rates ; Currency return predictability
[en] We compute a variance decomposition for the log exchange rate based on a present-value relation. At long horizons, return predictability drives the variation in the exchange rate while predictability of future interest rate differentials plays a secondary role. At shorter horizons, the dominant source is predictability of the future spot rate. There is more return predictability and less interest spread and exchange rate predictability in the case of real exchange rates compared to nominal exchange rates. An alternative decomposition based on a first-order VAR tends to overstate the importance of predictability of future interest spreads and exchange rates.

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