Liquidity premiums, interest rate differentials, and nominal exchange rate prediction

Abstract

AbstractWith the use of daily panel data for industrial countries, we study the essentialness of liquidity premiums and interest rate differentials in predicting nominal exchange rates at short horizons. We find that information about higher‐order moments of exchange rates helps predict nominal exchange rates. Before the global financial crisis, interest rate differentials were crucial for forecasting exchange rates. Interest rate differentials and liquidity premia provide additional information for predicting nominal exchange rates in the post‐crisis period even if we have controlled for latent fundamental exchange rates. Moreover, the economic significance analysis results echo those of the statistical significance analysis.