Global Investor Expectations and Exchange Rate

Ching-Tse Chen, Finance PhD student

The project aims to explore the heterogeneity and commonality in investor expectation errors across countries and empirically document their contribution to predictability of exchange rate. In particular, I would like to test whether there exists a consistent pattern in investors’ expectation errors for the short-term interest rate over the business cycle globally and whether they induce predictability for exchange rate not explained by time-varying risk premium. In the literature, errors in U.S. investors’ expectations about the short-term interest rate are documented to be large and persistent, especially during periods of recessions and Fed quantitative easings, and are found to predict excess returns on Treasury bonds. In this study, I will investigate whether the predictable errors in US investor expectations—negligence of relevant information and failure to foresee economic downturns—is common across countries. Moreover, given the apparent connection between exchange rates and interest rates, I will show predictable errors in short-term interest rate and exchange rate are linked and they contribute to ex post predictability of exchange rate and excess currency returns not due to time-varying risk premium found in the literature.