Statistical and Economic Methods for Evaluating Exchange Rate Predictability

Abstract

This chapter provides a comprehensive review of the statistical and economic methods used for evaluating out-of-sample exchange rate predictability. We illustrate these methods by assessing the forecasting performance of a set of widely used empirical exchange rate models using monthly returns on nine major US dollar exchange rates. We …nd that empirical models based on uncovered interest parity, purchasing power parity and the asymmetric Taylor rule perform better than the random walk in out-of-sample forecasting using both statistical and economic criteria. We also con…rm that conditioning on monetary fundamentals does not generate out-ofsample economic value. Finally, combined forecasts formed using a variety of model averaging methods perform better than individual empirical models. These results are robust to reasonably high transaction costs, the choice of numeraire and the exclusion of any one currency from the investment opportunity set.

Point, Interval and Density Forecasts of Exchange Rates with Time Varying Parameter Models

“…The positive realized utility might in fact be undone, if a given strategy requires many portfolio changes and if transaction costs are sufficiently high. Following Della Corte and Tsiakas () and Han () we calculate the breakeven transaction cost τ that must be paid in each month to make investors indifferent between two strategies. A strategy is preferred to the benchmark only if actual transaction costs are lower than the breakeven cost.…”

Performance of Survey Forecasts by Professional Analysts: Did the European Debt Crisis Make it Harder or Perhaps Even Easier?

“…One ground breaking work of Theil [15] can be dated back almost 60 years, for example. Since then, researchers have evaluated professional forecasters' performance in a broad spectrum of financial market times series ranging from equity markets (see for example Guedj and Bouchaud [16] as well as Spiwoks and Hein [17] and Bessler and Stanzel [18]), foreign exchange markets (see for example Lai [19] and more recently Della Corte et al [20]) as well as interest rate forecasts (see for example Friedman [21], Belongia [22] and more recently Gubaydullina, Hein and Spiwoks [23]). …”

Can currency-based risk factors help forecast exchange rates?

“…1 It has become a widely accepted view in international finance that individual exchange rates closely follow random walks (Engel and West (2005), Della Corte and Tiakas (2012), and Verdelhan (2013)). …”