DP11970 The Quanto Theory of Exchange Rates

Author(s): Lukas Kremens, Ian Martin
Publication Date: April 2017
Keyword(s): carry trade, currency, Exchange rate, exchange rate forecast, Forecasting, predictability, quanto contracts
JEL(s): F31, F37, F47, G12, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11970

We present a new, theoretically motivated, forecasting variable for exchange rates that is based on the prices of quanto index contracts, and show via panel regressions that the quanto forecast variable is a statistically and economically significant predictor of currency appreciation. We also test the quanto variable's ability to forecast differential currency appreciation out of sample, and find that it outperforms predictions based on uncovered interest parity, on purchasing power parity, and on a random walk.