Hostname: page-component-745bb68f8f-mzp66 Total loading time: 0 Render date: 2025-01-20T17:44:11.231Z Has data issue: false hasContentIssue false
  • English
  • Français

Model Uncertainty and Exchange Rate Forecasting

Published online by Cambridge University Press:  20 February 2017

Roy Kouwenberg ,
Agnieszka Markiewicz ,
Ralph Verhoeks  and
Remco C. J. Zwinkels
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

Exchange rate models with uncertain and incomplete information predict that investors focus on a small set of fundamentals that changes frequently over time. We design a model selection rule that captures the current set of fundamentals that best predicts the exchange rate. Out-of-sample tests show that the forecasts made by this rule significantly beat a random walk for 5 out of 10 currencies. Furthermore, the currency forecasts generate meaningful investment profits. We demonstrate that the strong performance of the model selection rule is driven by time-varying weights attached to a small set of fundamentals, in line with theory.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 52 , Issue 1 , February 2017 , pp. 341 - 363
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2017 

Footnotes

1 We thank Gurdip Bakshi (associate editor and the referee), Stephen Brown (the editor), André Lucas, Lukas Menkhoff, Maurizio Montone, Andreas Pick, Peter Schotman, Raman Uppal, Vadym Volosovych, and Casper de Vries for their insightful comments, as well as participants of the Forecasting Structure and Time Varying Patterns in Economics and Finance conference at Erasmus University Rotterdam, seminar participants at ISCTE Business School, Maastricht University, VU University Amsterdam, and Katholieke Universiteit Leuven. We especially thank Lucio Sarno for kindly providing us with the real-time data and Arlette Leeflang for excellent research assistance.

References

Bacchetta, P., and van Wincoop, E.. “A Scapegoat Model of Exchange Rate Determination.” American Economic Review, Papers and Proceedings, 94 (2004), 114–118.Google Scholar
Bacchetta, P., and van Wincoop, E.. “Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?” American Economic Review, 96 (2006), 552–576.Google Scholar
Bacchetta, P., and van Wincoop, E.. “On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals.” Journal of International Economics, 91 (2013), 18–26.Google Scholar
Bakshi, B., and Panayotov, G.. “Predictability of Currency Carry Trades and Asset Pricing Implications.” Journal of Financial Economics, 110 (2013), 139–163.Google Scholar
Benigno, G., and Thoenissen, C.. “Consumption and Real Exchange Rates with Incomplete Markets and Non-Traded Goods.” Journal of International Money and Finance, 27 (2008), 926–948.Google Scholar
Buckland, S. T.; Burnham, K. P.; and Augustin, N. H.. “Model Selection: An Integral Part of Inference.” Biometrics, 53 (1997), 603–618.Google Scholar
Chen, Y., and Rogoff, K. S.. “Commodity Currencies.” Journal of International Economics, 60 (2003), 133–160.Google Scholar
Chen, Y.; Rogoff, K. S.; and Rossi, B.. “Can Exchange Rates Forecast Commodity Prices?” Quarterly Journal of Economics, 125 (2010), 1145–1194.Google Scholar
Cheung, Y.-W., and Chinn, M. D.. “Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market.” Journal of International Money and Finance, 20 (2001), 439–471.Google Scholar
Cheung, Y.-W.; Chinn, M. D.; and Pascual, A. G.. “Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?” Journal of International Money and Finance, 24 (2005), 1150–1175.Google Scholar
Clark, T., and West, K. D.. “Approximately Normal Tests for Equal Predictive Accuracy in Nested Models.” Journal of Econometrics, 138 (2007), 291–311.Google Scholar
Della Corte, P.; Sarno, L.; and Tsiakas, I.. “An Economic Evaluation of Empirical Exchange Rate Models.” Review of Financial Studies, 22 (2009), 3491–3530.Google Scholar
Della Corte, P., and Tsiakas, I.. “Statistical and Economic Methods for Evaluating Exchange Rate Predictability.” In Handbook of Exchange Rates, James, J., Marsh, I. W., and Sarno, L., eds. Hoboken, NJ: Wiley (2012), 221–263.Google Scholar
Ferraro, D.; Rogoff, K. S.; and Rossi, B.. “Can Oil Prices Forecast Exchange Rates? An Empirical Analysis of the Relationship between Commodity Prices and Exchange Rates.” Journal of International Money and Finance, 54 (2015), 116–141.Google Scholar
Fratzscher, M.; Rime, D.; Sarno, L.; and Zinna, G.. “The Scapegoat Theory of Exchange Rates: The First Tests.” Journal of Monetary Economics, 70 (2015), 1–21.Google Scholar
Garratt, A., and Mise, E.. “Forecasting Exchange Rates Using Panel Model and Model Averaging.” Economic Modelling, 37 (2014), 32–40.Google Scholar
Granger, C. W. J., and Newbold, P.. Forecasting Economic Time Series, 2nd ed. New York, NY: Academic Press (1986).Google Scholar
Hendry, D. Dynamic Econometrics. Oxford, UK: Oxford University Press (1995).Google Scholar
Hodrick, R. J., and Prescott, E. C.. “Postwar U.S. Business Cycles: An Empirical Investigation.” Journal of Money, Credit and Banking, 29 (1997), 1–16.Google Scholar
Lai, T. L., and Xing, H.. Statistical Models and Methods in Financial Markets. New York, NY: Springer (2008).Google Scholar
Mark, N. C.“Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability.” American Economic Review, 85 (1995), 201–218.Google Scholar
Markiewicz, A.“Model Uncertainty and Exchange Rate Volatility.” International Economic Review, 53 (2012), 815–844.Google Scholar
Meese, R. A., and Rogoff, K. S.. “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics, 14 (1983), 345–373.Google Scholar
Menkhoff, L.; Sarno, L.; Schmeling, M.; and Schrimpf, A.. “Carry Trades and Global Foreign Exchange Volatility.” Journal of Finance, 67 (2012a), 681–718.Google Scholar
Menkhoff, L.; Sarno, L.; Schmeling, M.; and Schrimpf, A.. “Currency Momentum Strategies.” Journal of Financial Economics, 106 (2012b), 660–684.Google Scholar
Molodtsova, T., and Papell, D. H.. “Out-of-Sample Exchange Rate Predictability with Taylor Rule Fundamentals.” Journal of International Economics, 77 (2009), 167–180.Google Scholar
Morales-Arias, L., and Moura, G. V.. “Adaptive Forecasting of Exchange Rates with Panel Data.” International Journal of Forecasting, 29 (2013), 493–509.Google Scholar
Newbold, P., and Harvey, I. H.. “Forecast Combination and Encompassing.” In A Companion to Economic Forecasting, Clements, M. P. and Hendry, D. F., eds. New York, NY: Blackwell (2002), 268–283.Google Scholar
Pesaran, M. H., and Timmermann, A.. “A Simple Nonparametric Test of Predictive Performance.” Journal of Business and Economic Statistics, 10 (1992), 461–465.Google Scholar
Pojarliev, M., and Levich, R. M.. “Are All Currency Managers Equal?” Journal of Portfolio Management, 64 (2010), 42–53.Google Scholar
Qi, M., and Wu, Y.. “Technical Trading-Rule Profitability, Data Snooping, and Reality Check: Evidence from the Foreign Exchange Market.” Journal of Money, Credit and Banking, 30 (2006), 2135–2158.Google Scholar
Rossi, B.“Are Exchange Rates Really Random Walks? Some Evidence Robust to Parameter Instability.” Macroeconomic Dynamics, 10 (2006), 20–38.Google Scholar
Rossi, B.“Exchange Rate Predictability.” Journal of Economic Literature, 51 (2013), 1063–1119.Google Scholar
Sarkissian, S.“Incomplete Consumption Risk Sharing and Currency Risk Premiums.” Review of Financial Studies, 16 (2003), 983–1005.Google Scholar
Sarno, L., and Valente, G.. “Exchange Rates and Fundamentals: Footloose or Evolving Relationship?” Journal of European Economic Association, 7 (2009), 786–830.Google Scholar
Schinasi, G. J., and Swamy, P. A. V. B.. “The Out-of-Sample Forecasting Performance of Exchange Rate Models When Coefficients Are Allowed to Change.” Journal of International Money and Finance, 8 (1989), 375–390.Google Scholar
Sharpe, W. F.“Mutual Fund Performance.” Journal of Business, 39 (1966), 119–138.Google Scholar
Sullivan, R.; Timmermann, A.; and White, H.. “Data-Snooping, Technical Trading Rule Performance, and the Bootstrap.” Journal of Finance, 54 (1999), 1647–1692.Google Scholar
Timmermann, A.“Forecast Combinations.” In Handbook of Economic Forecasting, Elliott, G., Granger, C. W. J., and Timmermann, A., eds. Amsterdam, Netherlands: Elsevier (2006), 135–196.Google Scholar
White, H.“A Reality Check for Data Snooping.” Econometrica, 68 (2000), 1097–1127.Google Scholar
Wright, J. H.“Bayesian Model Averaging and Exchange Rate Forecasting.” Journal of Econometrics, 146 (2008), 329–341.Google Scholar