Dynamic asymmetry of exchange rates, interest rate differentials and currency crash risk

In this paper, we propose an unified econometric strategy to revisit the predictive contentof interest rates for exchange rate returns. The novelty of our approach is to take into account dependencies of higher orders by allowing for a time-varying asymmetry componentin the distribution of exchange rates, therefore explicitly modeling the effect of interestrates on extreme events. Using daily data on USD/EUR currency pair over the period1999-2019, we find the dynamic asymmetry component to be significant and driven byinterest rate differentials, but also by general uncertainty and past unexpected shocks. Inline with recent currency crash theories, our study suggests that the larger the differencebetween interest rates, the more likely the high yield currency is to appreciate but also toexperience currency crashes. To assess the economic significance of our results, we introduce a directional forecasting approach derived from our model. We show that a tradingrule based on these forecasts provides better in-sample and out-of-sample economic performance compared to benchmark models