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Exchange rates and interest rates: can term structure models explain currency movements?

✍ Scribed by Ahmet Can Inci; Biao Lu

Publisher: Elsevier Science
Year: 2004
Tongue: English
Weight: 353 KB
Volume: 28
Category: Article
ISSN: 0165-1889
DOI: 10.1016/s0165-1889(03)00081-2

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✦ Synopsis

We construct an international term structure model that has excellent empirical performance in tracking movements of exchange rates and currency returns. The forward premium puzzle is accounted for, yet the model does not have the undesirable properties found in Backus et al. (J. Finance 56 (2001) 279). Examination of the estimated factor structure indicates that local factors are not important in the US, UK, and German markets. Moreover, we ÿnd that term structure factors alone cannot satisfactorily explain exchange rate movements. In other words, exchange rates are also a ected by other factors that are not in the interest rate dynamics.

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