Can interest rate factors explain exchange rate fluctuations?

This paper explores whether interest rate factors, derived from the yield curve, can explain exchange rate fluctuations at different horizons. Using a dynamic term structure model under no-arbitrage, exchange rates are modeled as the ratio of two countries’ stochastic discount factors. Key to this framework is that factors are observable, which allows the model to be estimated by Maximum Likelihood. Results show that interest rate factors can explain half of the variation in one-year exchange rates and up to ninety percent of five-year movements, for free-floating currencies from 1999 to 2014. These findings suggest that yield curves contain important information for modeling exchange rate dynamics, particularly at longer horizons.