The level, slope, and curvature of the yield curve are known predictors of excess bond returns and economic activity, reflecting time variation in investors’ risk premia. In this paper, I develop a term structure model under complete markets and no arbitrage that describes exchange rate fluctuations as a function of these interest rate factors. The Gaussian properties of the stochastic discount factors imply non-linearities in exchange rate risk premia that can account for up to half of the in-sample variation in one-year currency returns for different country pairs during the 1980s–2016 period. Interest rate factors can help explain exchange rate fluctuations in and out of sample, particularly at longer horizons, and yield profitable currency portfolios relative to standard carry trade strategies.

• main.py contains the code for foreign exchange forecasting model.
• data folder contains all the data files required for running the forecasting model.
• imports.py contains imports of all python packages necessary for running the foreign exchange forecasting model code.

• This code reproduces the out-of-sample forecasting exercise in Section 7, following Equation (B.37) derived in the Online Appendix.
• If you use the code, please cite the paper as follows: Yung, J., 2021. Can interest rate factors explain exchange rate fluctuations? Journal of Empirical Finance 61, 34-56.