The predictive performance of the currency futures basis for spot returns

Abstract

This paper investigates the predictive performance of the futures basis in directly forecasting currency spot returns and compares it with that of the one-month forward basis. We consider the settle prices of both front-month and nearby-month continuous futures contracts and find that the futures basis exhibits statistically and economically significant in-sample and out-of-sample forecasting power, which clearly exceeds that of the well-known forward basis. The empirical results show that spot returns correspond negatively to both the front-month futures basis and nearby-month futures basis. Furthermore, the futures basis reveals substantial economic value for investors in terms of sizable and tangible portfolio gains, which are consistent with statistical measures. The difference in the forecasting ability of the futures basis and forward basis can be explained by the level of exposure to the time-varying risk premium. Finally, we find that impacts of the futures basis on spot returns vary with time and experienced substantial structural changes during the Global Financial Crisis.

Keywords:

• Currency spot returns
• Futures basis
• Out-of-sample forecasts
• Time-varying predictability
• Economic value
• Time-varying risk premium

Notes

1 There are many empirical studies, and we list only a few of them. Early studies include Fama (1984), Hsieh (1984) and Engel (1996). Recent studies include Nikolaou and Sarno (2006), James et al. (2009), Boudoukh Richardson and Whitelaw (2016) and Londono and Zhou (2017), etc.

2 Forward basis (s-f) is the spread between (log) spot exchange rate s and (log) forward exchange rate f. Most studies find that the forward premium inversely predicts the future spot exchange rate change (Sercu and Vinaimont 2006; Chakraborty and Evans 2008; Wang and Wang 2009; Frankel and Poonawala 2010). The forward basis (S-F) and forward premium (F-S, the spread between forward exchange rate F and spot exchange rate S) are just opposite in sign, which indicates that the forward basis is positively related to spot exchange rate change.

3 The futures contracts roll on the first day of the delivery month of the expiring or front contract. If the front contract expires before the first day of the delivery month, then contracts roll on the expiry date instead. All settle prices of these continuous contracts are not adjusted in any way; they just reflect raw prices from the underlying contracts.

4 Sakoulis et al. (2010) argue that the persistence of the forward discount is exaggerated because of the presence of structural breaks. However, there are no structural breaks in the AR process for the futures basis and forward basis. Thus, it will not be discussed further.

5 None of the economic models in the empirical analysis of Meese and Rogoff (1983), including the random walk with drift model, generally yields any forecasting improvement in root mean square error or mean absolute error over the random walk model. Since then, the random walk (without drift) has been widely used as a benchmark model in predicting exchange rates (Della Corte and Tsiakas 2012; Hashimoto et al. 2012; Rossi 2013; Li et al. 2015, etc.).

6 The procedures employed in this paper to determine the number of breaks are as follows: the Bayesian Information Criterion (BIC), the modified Schwarz criterion (LWZ), and the sequential procedure (using a 5% significance level) proposed by Bai and Perron (2003).

Additional information

Funding

This research is financially supported by the National Natural Science Foundation of China under project No. 71671193 and No. 71673020 and the Program for Innovation Research in Central University of Finance and Economics.