Working Paper: NBER ID: w25714
Authors: Charles W. Calomiris; Harry Mamaysky
Abstract: We develop an empirical model of exchange rate returns, applied separately to samples of developed (DM) and developing (EM) economies’ currencies against the dollar. Monetary policy stance of the global central banks, measured via a natural-language-based approach, has a large effect on exchange rate returns over the ensuing year, is closely linked to the VIX, and becomes increasingly important in the post-crisis era. We document an important spillover effect: monetary policy of the Bank of England, the Bank of Japan and the ECB is as important as Fed policy in forecasting currency returns against the dollar. In the post-crisis era, a one standard deviation increase in dovishness of all four central banks forecasts a 5.8% (4.0%) one-year excess return of DM (EM) currencies. Furthermore, we find that the relation between a DM country’s interest rate differential relative to the dollar (carry) and the future returns from investing in its currency switches sign from the pre- to the post-crisis subperiod, while for EMs the carry variable is never a significant predictor of returns. The high profit from the carry trade for EM currencies reflects persistent country characteristics likely reflective of risk rather than the interest differential per se. While measures of global monetary policy stance forecast exchange rate returns against the dollar, they do not predict exchange rate returns against other base currencies. Results regarding returns from carry, however, are insensitive to the choice of the base currency. We construct a no-arbitrage pricing model which reconciles many of our empirical findings.
Keywords: Monetary Policy; Exchange Rates; Risk Regimes
JEL Codes: E4; F31; F34; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy stance of global central banks (E52) | Exchange rate returns (F31) |
| Dovishness across the four major central banks (E52) | Exchange rate returns (F31) |
| Monetary policy of non-U.S. central banks (E52) | Dollar appreciation against other currencies (F31) |
| Interest rate differential of developed market countries (E43) | Future currency returns (F31) |
| Risk factors related to the global economy (F65) | Exchange rate returns (F31) |