What Drives Exchange Rates? Reassessing Currency Return Predictability

Abstract

We compute a variance decomposition for the exchange rate based on a present-value relation. At long horizons, return predictability drives the variation in the exchange rate while predictability of future interest rate differentials plays a secondary role. At shorter horizons, the dominant force is predictability of the future spot rate. There is more (less) return (interest spread) predictability in the case of real exchange rates compared to nominal exchange rates. An alternative decomposition based on a first-order VAR tends to overstate the importance of predictability of future interest spreads and exchange rates. Along the cross-sectional dimension, we find that the dispersion in the average rate of appreciation of foreign currencies is mainly due to predictability of interest rate spreads.