Forecasting Errors, Directional Accuracy and Profitability of Currency Trading: The Case of EUR/USD Exchange Rate

Abstract

We provide a comprehensive study of out-of-sample forecasts for the EUR/USD exchange rate based on multivariate macroeconomic models and forecast combinations. We use profit maximization measures based on directional accuracy and trading strategies in addition to standard loss minimization measures. When comparing predictive accuracy and profit measures, data snooping bias free tests are used. The results indicate that forecast combinations, in particular those based on principal components of forecasts, help to improve over benchmark trading strategies, although the excess return per unit of deviation is limited.JEL codes: C53, F31, F37

Exchange rate forecasting and the performance of currency portfolios

“…For a forecast horizon of 12 months, however, we only observe a positive economic value of portfolio optimization but not of 2 This issue is the main focus of Costantini et al (2016). forecasting, and also not of portfolio optimization and forecasting. First, there is economic value which can be exclusively attributed to portfolio optimization and can be assessed by comparing the performance of optimal portfolios with the performance of the equally weighted portfolio based on composite forecasts.…”

“…This applies for the mean-variance and conditional-value-at-risk optimal portfolios with respect to the equally weighted portfolio. For a forecast horizon of 12 months, however, we only observe a positive economic value of portfolio optimization but not of 2 This issue is the main focus of Costantini et al (2016). forecasting, and also not of portfolio optimization and forecasting.…”

“…The set of methods used to create forecast combinations from individual multivariate time series models is similar to that in Costantini et al (2016). Let S t be the spot …”

“…These are the same methods that have been recently used in Costantini et al (2016) to evaluate exchange rate predictability: 3 These are the same methods that have been recently used in Costantini et al (2016) to evaluate exchange rate predictability: 3…”

“…The class of specifications we entertain in order to obtain forecasts of the exchange rate can be conceptualized in the context of the so-called monetary model of exchange rates originally developed in the work by, for example, Frenkel (1976), Dornbusch (1976), or Hooper andMorton (1982). The monetary model of exchange rate determination has been often used as a theoretical framework to create exchange rate predictions based on macroeconomic fundamentals (see Costantini et al, 2016;Crespo Cuaresma & Hlouskova, 2005). Starting with standard Cagan money demand equations for the domestic and foreign economy, the monetary model of exchange rate formation assumes that purchasing power parity acts as a long-run equilibrium and thus leads to a relationship between the exchange rate on the one hand and money supply, interest rates, and income levels in the two economies on the other hand.…”