The Quanto Theory of Exchange Rates
American Economic Review · 2019 · Volume 109 · Issue 3
Abstract
We present a new identity that relates expected exchange rate appreciation to a risk-neutral covariance term, and use it to motivate a currency forecasting variable based on the prices of quanto index contracts. We show via panel regressions that the quanto forecast variable is an economically and statistically significant predictor of currency appreciation and of excess returns on currency trades. Out of sample, the quanto variable outperforms predictions based on uncovered interest parity, on purchasing power parity, and on a random walk as a forecaster of differential (dollar-neutral) currency appreciation.
Keywords
Forecasting Models, Simulation Methods, Interest Rates: Determination, Term Structure, and Effects, Foreign Exchange, International Finance Forecasting and Simulation: Models and Applications, Asset Pricing, Trading Volume, Bond Interest Rates, International Financial Markets
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