The predictive content of oil price and volatility: New evidence on exchange rate forecasting

We propose oil price volatility as a new fundamental for exchange rate forecasting. This fundamental parallels recent theoretical developments in international finance to resolve the disconnect between macro variables and exchange rates. By focusing on small open economies that export oil, we then provide a comprehensive empirical evaluation of the forecasting performance of the fundamental in multiple countries. We find that oil price and volatility contain out-of-sample predictive content for the exchange rate at daily frequency, especially when crude oil represents a significant fraction of the country’s exports and when there are strong trade ties between the currency areas. We also discover that directional change, i.e. appreciation or depreciation, can be forecasted even in the absence of point forecastability. Our findings are robust to forecast evaluation method, volatility measure and evaluation period, thus supporting the role of financial channels in exchange rate determination. Moreover, the predictive content dissipates when we move from daily to monthly frequency, suggesting that temporal data aggregation may explain the failure to find predictability in past work using monthly or quarterly data.