Currency forecast errors and carry trades at times of low interest rates: Evidence from survey data on the yen/dollar exchange rate. (May 2015) - MacDonald, Ronald
Abstract: Using survey expectations data and a variant of the uncovered interest rate parity (UIRP), this paper evaluates the relationship between interest rates and investors' forecast errors about the yen/dollar exchange rate. This study therefore is related to the forward premium puzzle and the currency carry trade strategy. Using relatively short (i.e., 1 to 6 month-ahead) forecast data, we obtain the following results. First, with the same forecast horizon, exchange rate forecasts are homogeneous among different industry types, but within the same industry, exchange rate forecasts differ if the forecast time horizon is different. Second, while forecast errors are found to be partly driven by interest rate spreads, evidence against the UIRP is provided. Consistent with this finding, our coefficients on interest rate spreads obtained from nonlinear models provide indirect evidence of the yen carry trade. In particular, unlike theoretical predictions, the carry trade is found to be active during financial turmoil and when there is a clear indication that the interest rate will be low in the future. Highlights: With the same forecast horizon, exchange rate forecasts from survey data are homogeneous among different industry types. But within the same industry, exchange rate forecasts differ if the forecast time horizon is different. There is evidence of the forward premium puzzle and the carry trade strategies. The carry trade was active at times with clear signs of low interest rates in future.