Advanced Search
MyIDEAS: Login to save this paper or follow this series

Forecasting Exchange Rates: An Investor Perspective

Contents:

Author Info

  • Michael Melvin
  • John Prins
  • Duncan Shand
Registered author(s):

    Abstract

    The popular scholarly exercise of evaluating exchange rate forecasting models relative to a random walk was stimulated by the well-cited Meese and Rogoff (1983) paper. Practitioners who construct quantitative models for trading exchange rates approach forecasting from a different perspective. Rather than focus on forecast errors for bilateral exchange rates, as in the Meese-Rogoff case, we present what is required for constructing a successful trading model. To provide more perspective, a particular approach to quantitative modeling is presented that incorporates return forecasts, a risk model, and a transaction cost constraint in an optimization framework. Since beating a random walk is not a useful evaluation metric for currency investing, we discuss the use of benchmarks and conclude that performance evaluation in currencies is much more problematic than in equity markets due to the lack of a passive investment strategy and the multitude of alternative formulations of well-known currency style factors. We then provide analytical tools that can be useful in evaluating currency manager skill in terms of portfolio tilts and timing. Finally, we examine how conditioning information can be employed to enhance timing skill in trading generic styles like the carry trade. Such information can be valuable in reducing the duration and magnitude of portfolio drawdowns.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2013/wp-cesifo-2013-05/cesifo1_wp4238.pdf
    Download Restriction: no

    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 4238.

    as in new window
    Length:
    Date of creation: 2013
    Date of revision:
    Handle: RePEc:ces:ceswps:_4238

    Contact details of provider:
    Postal: Poschingerstrasse 5, 81679 Munich
    Phone: +49 (89) 9224-0
    Fax: +49 (89) 985369
    Email:
    Web page: http://www.cesifo.de
    More information through EDIRC

    Related research

    Keywords: exchange rate forecasting; forecast evaluation; conditioners; quantitative models; benchmarks;

    Find related papers by JEL classification:

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    as in new window
    1. Craig Burnside & Martin S. Eichenbaum & Sergio Rebelo, 2011. "Carry Trade and Momentum in Currency Markets," NBER Working Papers 16942, National Bureau of Economic Research, Inc.
    2. Richard Clarida & Josh Davis & Niels Pedersen, 2009. "Currency Carry Trade Regimes: Beyond the Fama Regression," NBER Working Papers 15523, National Bureau of Economic Research, Inc.
    3. Burnside, A Craig & Eichenbaum, Martin & Kleshchelski, Isaac & Rebelo, Sérgio, 2008. "Do Peso Problems Explain the Returns to the Carry Trade?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6873, C.E.P.R. Discussion Papers.
    4. Elliott, Graham & Ito, Takatoshi, 1999. "Heterogeneous expectations and tests of efficiency in the yen/dollar forward exchange rate market," Journal of Monetary Economics, Elsevier, Elsevier, vol. 43(2), pages 435-456, April.
    5. Shanken, Jay, 1987. " Nonsynchronous Data and the Covariance-Factor Structure of Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 42(2), pages 221-31, June.
    6. de Zwart, G.J. & Markwat, T.D. & Swinkels, L.A.P. & van Dijk, D.J.C., 2007. "The Economic Value of Fundamental and Technical Information in Emerging Currency Markets," ERIM Report Series Research in Management, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasm ERS-2007-096-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
    7. Ben S. Bernanke & Kenneth Rogoff, 2001. "Editorial in "NBER Macroeconomics Annual 2000, Volume 15"," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 2000, Volume 15, pages 1-4 National Bureau of Economic Research, Inc.
    8. Ben S. Bernanke & Kenneth Rogoff, 2001. "NBER Macroeconomics Annual 2000, Volume 15," NBER Books, National Bureau of Economic Research, Inc, National Bureau of Economic Research, Inc, number bern01-1.
    9. John Williamson, 2009. "Exchange Rate Economics," Open Economies Review, Springer, Springer, vol. 20(1), pages 123-146, February.
    10. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 0. "Common Risk Factors in Currency Markets," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 24(11), pages 3731-3777.
    11. Bessembinder, Hendrik, 1994. "Bid-ask spreads in the interbank foreign exchange markets," Journal of Financial Economics, Elsevier, Elsevier, vol. 35(3), pages 317-348, June.
    12. Illing, Mark & Liu, Ying, 2006. "Measuring financial stress in a developed country: An application to Canada," Journal of Financial Stability, Elsevier, Elsevier, vol. 2(3), pages 243-265, October.
    13. Hiroshi Konno & Hiroaki Yamazaki, 1991. "Mean-Absolute Deviation Portfolio Optimization Model and Its Applications to Tokyo Stock Market," Management Science, INFORMS, INFORMS, vol. 37(5), pages 519-531, May.
    14. Cheung, Yin-Wong & Chinn, Menzie D. & Pascual, Antonio Garcia, 2005. "Empirical exchange rate models of the nineties: Are any fit to survive?," Journal of International Money and Finance, Elsevier, Elsevier, vol. 24(7), pages 1150-1175, November.
    15. Habib, Maurizio Michael & Stracca, Livio, 2011. "Getting beyond carry trade: what makes a safe haven currency?," Working Paper Series, European Central Bank 1288, European Central Bank.
    16. Melvin, Michael & Taylor, Mark P, 2009. "The Crisis in the Foreign Exchange Market," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7472, C.E.P.R. Discussion Papers.
    17. Okunev, John & White, Derek, 2003. "Do Momentum-Based Strategies Still Work in Foreign Currency Markets?," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 38(02), pages 425-447, June.
    18. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 96(1), pages 116-31, February.
    19. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, American Economic Association, vol. 33(1), pages 13-47, March.
    20. Hartmann, Philipp, 1999. "Trading volumes and transaction costs in the foreign exchange market: Evidence from daily dollar-yen spot data," Journal of Banking & Finance, Elsevier, Elsevier, vol. 23(5), pages 801-824, May.
    21. Christensen, Kim & Kinnebrock, Silja & Podolskij, Mark, 2010. "Pre-averaging estimators of the ex-post covariance matrix in noisy diffusion models with non-synchronous data," Journal of Econometrics, Elsevier, Elsevier, vol. 159(1), pages 116-133, November.
    22. Menkhoff, Lukas & Taylor, Mark P., 2006. "The Obstinate Passion of Foreign Exchange Professionals : Technical Analysis," The Warwick Economics Research Paper Series (TWERPS), University of Warwick, Department of Economics 769, University of Warwick, Department of Economics.
    23. Charles Engel & Nelson C. Mark & Kenneth D. West, 2007. "Exchange Rate Models Are Not as Bad as You Think," NBER Working Papers 13318, National Bureau of Economic Research, Inc.
    24. Jorion, Philippe, 1985. "International Portfolio Diversification with Estimation Risk," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 58(3), pages 259-78, July.
    25. Neely, Christopher J. & Weller, Paul A. & Ulrich, Joshua M., 2009. "The Adaptive Markets Hypothesis: Evidence from the Foreign Exchange Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 44(02), pages 467-488, April.
    26. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, Elsevier, vol. 14(1-2), pages 3-24, February.
    27. Glassman, Debra, 1987. "Exchange rate risk and transactions costs: Evidence from bid-ask spreads," Journal of International Money and Finance, Elsevier, Elsevier, vol. 6(4), pages 479-490, December.
    28. Pojarliev, Momtchil & Levich, Richard M., 2010. "Trades of the living dead: Style differences, style persistence and performance of currency fund managers," Journal of International Money and Finance, Elsevier, Elsevier, vol. 29(8), pages 1752-1775, December.
    29. Lukas Menkhoff & Lucio Sarno & Maik Schmeling & Andreas Schrimpf, 2012. "Carry Trades and Global Foreign Exchange Volatility," Journal of Finance, American Finance Association, American Finance Association, vol. 67(2), pages 681-718, 04.
    30. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," NBER Working Papers 14473, National Bureau of Economic Research, Inc.
    31. Kroner, Kenneth F & Ng, Victor K, 1998. "Modeling Asymmetric Comovements of Asset Returns," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 11(4), pages 817-44.
    32. Jessica James, 2003. "Simple trend-following strategies in currency trading," Quantitative Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 3(4), pages 75-77.
    33. Tarun Ramadorai, 2008. "What determines transaction costs in foreign exchange markets?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 13(1), pages 14-25.
    34. Pasquale Della Corte & Lucio Sarno & Ilias Tsiakas, 2009. "An Economic Evaluation of Empirical Exchange Rate Models," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(9), pages 3491-3530, September.
    35. Momtchil Pojarliev & Richard M. Levich, 2007. "Do Professional Currency Managers Beat the Benchmark?," NBER Working Papers 13714, National Bureau of Economic Research, Inc.
    36. Treynor, Jack L & Black, Fischer, 1973. "How to Use Security Analysis to Improve Portfolio Selection," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 46(1), pages 66-86, January.
    Full references (including those not matched with items on IDEAS)

    Citations

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:ces:ceswps:_4238. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Julio Saavedra).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.