DP13835 Forward-Looking Policy Rules and Currency Premia

Author(s): Ilias Filippou, Mark P Taylor
Publication Date: July 2019
Keyword(s): currency risk premium, data snooping bias, foreign exchange, Taylor rules
JEL(s): F31, G11, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13835

We evaluate the cross-sectional predictive ability of a forward-looking monetary policy reaction function, or Taylor rule, in both statistical and economic terms. We find that investors require a premium for holding currency portfolios with high implied interest rates while currency portfolios with low implied rates offer negative currency excess returns. Our forward-looking Taylor rule signals are orthogonal to current nominal interest rates and disconnected from carry trade portfolios and other currency investment strategies. The profitability of the Taylor rule portfolio spread is mainly driven by inflation forecasts rather than the output gap and is robust to data snooping and a wide range of robustness checks.