The Quanto Theory of Exchange Rates

We present a new, theoretically motivated, forecasting variable for exchange rates that is based on the prices of quanto index contracts, and show via panel regressions that the quanto forecast variable is a statistically and economically significant predictor of currency appreciation and of excess returns on currency trades. We also test the quanto variable's ability to forecast differential currency appreciation out of sample, and find that it outperforms predictions based on uncovered interest parity, on purchasing power parity, and on a random walk.

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