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Predicting risk premia in short-term interest rates and exchange rates

Author

Listed:
  • Gräb, Johannes
  • Kostka, Thomas
Abstract
We assess the ability of yield curve factors to predict risk premia in short-term interest rates and exchange rates across a large sample of major advanced economies. We find that the same tick-shaped linear combination of (relative) bond yields predicts risk premia in both short-term interest rates and exchange rates at returnforecasting horizons of up to six months for all (but one) countries and currencies in our sample. Our single forecasting factor loads positively on the short and long end of the curve and negatively on the medium-term and is therefore inversely related to Nelson-Siegel’s curvature factor. In line with recent interpretations of the yield curve factors, our findings suggest that the hump of the yield curve bears important information about future short-term interest rates. A relatively high curvature predicts a surprise rise in short-term interest rates beyond expectations and, coincidentally, an appreciation of the home currency in line with uncovered interest rate parity. JEL Classification: C23, C53, G11

Suggested Citation

  • Gräb, Johannes & Kostka, Thomas, 2018. "Predicting risk premia in short-term interest rates and exchange rates," Working Paper Series 2131, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20182131
    Note: 999723
    as

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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecb.wp2131.en.pdf
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    References listed on IDEAS

    as
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    Cited by:

    1. Ferdinand Dreher & Johannes Gräb & Thomas Kostka, 2020. "From carry trades to curvy trades," The World Economy, Wiley Blackwell, vol. 43(3), pages 758-780, March.
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    3. Seungho Baek & Jeong Wan Lee & Kyong Joo Oh & Myoungji Lee, 2020. "Yield curve risks in currency carry forwards," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(4), pages 651-670, April.

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    More about this item

    Keywords

    exchange rates; interest rates; predictability; risk premia; yield curve;
    All these keywords.

    JEL classification:

    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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