| Abstract: |
We examine directional predictability in foreign exchange markets using a
model-free statistical evaluation procedure. Based on a sample of foreign
exchange spot rates and futures prices in six major currencies, we document
strong evidence that the directions of foreign exchange returns are
predictable not only by the past history of foreign exchange returns, but also
the past history of interest rate differentials, suggesting that the latter
can be a useful predictor of the directions of future foreign exchange rates.
This evidence becomes stronger when the direction of larger changes is
considered. We further document that despite the weak conditional mean
dynamics of foreign exchange returns, directional predictability can be
explained by strong dependence derived from higher-order conditional moments
such as the volatility, skewness and kurtosis of past foreign exchange
returns. Moreover, the conditional mean dynamics of interest rate
differentials contributes significantly to directional predictability. We also
examine the co-movements between two foreign exchange rates, particularly the
co-movements of joint large changes. There exists strong evidence that the
directions of joint changes are predictable using past foreign exchange
returns and interest rate differentials. Furthermore, both individual currency
returns and interest rate differentials are also useful in predicting the
directions of joint changes. Several sources can explain this directional
predictability of joint changes, including the level and volatility of
underlying currency returns. |