interest rates on three-month maturity government debt and the implied volatility measure, which as the previous section described, is derived from three-month options contracts on exchange rates. Our approach consists in using fixed-effects panel data tools, which later on we expand to construct impulse responses by local projections (Jordà, 2005 and 2009). Second, we determine the predictive ability of each of the competing factors considered from the perspective of a carry trader whose trades are constrained by three-month holding periods, but who is allowed to make trades every month. This approach respects the constraints of our data while allowing for a monthly frequency analysis. This is necessary to obtain sufficient out-of-sample observations to conduct credible tests of predictive ability using Giacomini and White (2006) procedures with a somewhat more realistic situation.

3.1 Design of the Local Projection Analysis In order to pursue the first objective we find it convenient to think of the multivariate process characterizing a bilateral relationship before scaling the set-up to our panel of

countries. Accordingly, let e_{τ denote the logarithm of the nominal exchange rate in }

quarter τ , expressed in currency units per $U.S. Let p_{τ denote the logarithm of the }

consumer price index so that π_{τ = ∆pτ denotes the quarterly inflation rate. Interest }

rates on three-month government debt (on a quarterly basis) are denoted as i_{τ and the }

implied volatility from three-month options contracts on exchange rates signed by ( τ τ i i − * ) a s τ V X ( w e u s e t h e s i g n o f t h e i n t e r e s t r a t e d i f f e r e n t i a l b e t w e e n i n v e s t m e n t

a n * d f u n d i n g c u r r e n c y b e c a u s e v o l a t i l i t y i s a s t r i c t l y p o s i t i v e v a r i a b l e ) . F i n a l l y , * τ p , τ π

a n d * τ i w i l l r e f e r t o t h e c o r r e s p o n d i n g q u a n t i t i e s f o r t h e b a s e c o u n t r y , i n t h i s c a s e , t h e

U.S. These variables can be thought of as forming part of the vector time series

∆y_{τ +1 }

=

⎢ ⎢ ⎢ ⎢ ⎣ ⎡ + + * + 1 1 * 1 τ τ ∆e_{τ +1 }−π_{τ +1 }− i_{τ +1 }τ π V X i

⎥ ⎥ ⎥ ⎥ ⎦ ⎤

(1)

9