Exchange Rate Predictability

Abstract

The main goal of this article is to provide an answer to the question: "Does anything forecast exchange rates, and if so, which variables?". It is well known that exchange rate ‡uctuations are very di¢ cult to predict using economic models, and that a random walk forecasts exchange rates better than any economic model (the Meese and Rogo¤ puzzle). However, the recent literature has identi…ed a series of fundamentals/methodologies that claim to have resolved the puzzle. This article provides a critical review of the recent literature on exchange rate forecasting and illustrates the new methodologies and fundamentals that have been recently proposed in an upto-date, thorough empirical analysis. Overall, our analysis of the literature and the data suggests that the answer to the question: "Are exchange rates predictable?" is, "It depends" -on the choice of predictor, forecast horizon, sample period, model, and forecast evaluation method. Predictability is most apparent when one or more of the following hold: the predictors are Taylor rule or net foreign assets, the model is linear, and a small number of parameters are estimated. The toughest benchmark is the random walk without drift.

The anomalous forward premium of EUR/RSD exchange rate

“…4 Engel & West (2005) provide a theoretical analysis of this paradox. Rossi (2013) provides a critical overview of the literature on exchange rate forecasting in general and empirically illustrates recent methodologies and various proposed fundamentals.…”

Exchange Rates Forecasting: Can Jump Models Combined with Macroeconomic Fundamentals Help?

“…Of course, there is a l ot of discussion about the PPP model itself, interested reader is referred to Rossi (2013) -as for any other regressor we introduce. …”

“…For example, it has been used in Li et al (2015) and Rossi (2013) states many other references where one can find this method in a certain form. We follow a process which is very close to Li et al (2015) and consists of these steps:…”

“…It is also difficult to find a robust prediction approach for different currency pairs since we observe that performance changes if we move from one pair to another, ceteris paribus. This unstability of results is a known fact (see Rossi (2013) for instance) and it underscores the problem of describing a robust connection between FX rates and macroeconomic variables. However, we hope we have exemplified a new approach to this problem that might be developed further and help in clarification of the exchange rate disconnect puzzle eventually.…”

“…In the literature, mostly they conclude that even though the standard macroeconomic models are able to (at least partially) describe in-sample movement of FX rate, however, out-of-sample forecast is rarely better than a (no-change) forecast of a random walk (with or without drift). There is a vast amount of literature on this topiccovering different methods of prediction, using various economic fundamentals, all applied on miscellaneous FX rates and time periods; for a good overview (and an exhaustive list of references) see the comprehensive study Rossi (2013) for instance. We try to provide a novel approach to forecasting of FX rates combining stochastic models with jumps, predictors based on standard macroeconomic models such as purchasing power parity, monetary fundamentals model, and Taylor-rule model, and techniques of regularized estimation with cross-validation.…”