ERN: Risk Premiums (Topic) | 2021
Enhanced Carry: Prospective Interest Rate Differential and Currency Excess Returns
Abstract
Following Engel (2011), we use a Beveridge-Nelson decomposition to link expected foreign currency excess returns to `prospective interest rate differential -- the infinite sum of expected future interest rate differentials. Empirically, we find that prospective interest rate differential is a stronger predictor of currency excess returns than carry, in both portfolio sorts and Fama-MacBeth regressions. A factor based on prospective interest rate differential is also useful in explaining the returns of currency carry and momentum portfolios.