Can Interest Rate Factors Explain Exchange Rate Fluctuations?

This paper explores whether interest rate factors, derived from the yield curve, can explain exchange rate fluctuations at different horizons. Using a dynamic term structure model under no-arbitrage, exchange rates are modeled as the ratio of two countries’ stochastic discount factors. Key to this framework is that factors are observable, which allows the model to be estimated by Maximum Likelihood. Results show that interest rate factors can explain half of the variation in one-year exchange rates and up to ninety percent of five-year movements, for free-floating currencies from 1999 to 2014. These findings suggest that yield curves contain important information for modeling exchange rate dynamics, particularly at longer horizons. JEL codes: G15, F31, E43 * Julieta Yung, Federal Reserve Bank of Dallas, Research Department, 2200 N. Pearl Street, Dallas, TX 75201. 214 922-5443. [email protected]. I am grateful to Tom Cosimano, Jun Ma, Mark Wohar, and many others for helpful comments and suggestions. This paper also benefited from comments made by the participants at the Macroeconomics Seminar and the Mathematical Finance Research Group at the University of Notre Dame. The views in this paper are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.