Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?

Abstract

Previous assessments of nominal exchange rate determination have focused upon a narrow set of models typically of the 1970's vintage. The canonical papers in this literature are by Rogoff (1983, 1988), who examined monetary and portfolio balance models. Succeeding works by Mark (1995) and Chinn and Meese (1995) focused on similar models. In this paper we re-assess exchange rate prediction using a wider set of models that have been proposed in the last decade: interest rate parity, productivity based models, and "behavioral equilibrium exchange rate" models. The performance of these models is compared against a benchmark model -the Dornbusch-Frankel sticky price monetary model. The models are estimated in error correction and first-difference specifications. Rather than estimating the cointegrating vector over the entire sample and treating it as part of the ex ante information set as is commonly done in the literature, we recursively update the cointegrating vector, thereby generating true ex ante forecasts. We examine model performance at various forecast horizons (1 quarter, 4 quarters, 20 quarters) using differing metrics (mean squared error, direction of change), as well as the Aconsistency@ test of Cheung and Chinn (1998). No model consistently outperforms a random walk, by a mean squared error measure; however, along a direction-of-change dimension, certain structural models do outperform a random walk with statistical significance. Moreover, one finds that these forecasts are cointegrated with the actual values of exchange rates, although in a large number of cases, the elasticity of the forecasts with respect to the actual values is different from unity. Overall, model/specification/currency combinations that work well in one period will not necessarily work well in another period.

Exchange Rate Misalignment—The Case of the Chinese Renminbi

“…Their result that these models 6 cannot out-perform a naive random-walk specification has proven robust. For many years researchers have found it difficult to reject the hypothesis that major country exchange rates follow a random walk under floating exchange rate regimes; see, for example, Meese and Rogoff (1983), Rogoff (1996) and, Cheung et al, (2005). An implication of this finding is that the prospect of having a commonly agreed framework to assess exchange rate misalignment is pretty unpromising.…”

Individual Exchange Rate Forecasts and Expected Fundamentals

“…As is now widely accepted, it is difficult to obtain a conclusive set of results from conventional tests of exchange rate models at this horizon (Cheung, Chinn, and Pascual, 2005;Engel and West, 2005) and so in this paper we propose another route.…”

“…Finally, market participants do not only use fundamentals but also non-fundamentals as information in their decision making (Menkhoff and Taylor, 2007). Each of these sources of complexity may explain why conventional tests of exchange rate models in the spirit of Meese and Rogoff (1983) -regressing exchange rate changes on changes in fundamentals -fail (Cheung, Chinn, and Pascual, 2005): the reason is not necessarily the above mentioned "disconnect" but possibly the use of a "false" model, i.e. a model that cannot account well enough for existing complex 1 relations.…”

Macro Approaches to Foreign Exchange Determination

“…First, Faust et al (2003) have shown that these long horizon results are specific to the particular time period examined, particularly in the case of Mark's study. 10 Second, examining a slightly different set of models, and taking into account the possibility of no-cointegration, Cheung, Chinn and Garcia Pascual (2005) find only very limited evidence of improved forecasting ability at long horizons, relative to shorter horizons. Specifically, they examine a more recent set of models developed over the last two decade --interest rate parity, 11 productivity based models, and "behavioral equilibrium exchange rate" models.…”