Exchange Rate Predictability with Nine Alternative Models for BRICS Countries

We examine exchange rate predictability using time-varying and constant parameter models that are conditioned on three variants of Taylor rules as well as six additional alternative models, namely, monetary model (MM); purchasing power parity (PPP); uncovered interest rate parity (UIRP) and three different factor (F1, F2 and F3) models, for BRICS countries. Monthly consumer price index, industrial production index, interest rate, broad money and exchange rates were used to construct the alternative fundamentals for exchange rate predictability for the period of January 1999 and March 2020. The out-of-sample forecast performances of the contending models were evaluated at the forecasting horizons of 1, 4, 8 and 12 using RMSFE and DM statistics, under the full, pre-GFC and post-GFC sample periods. We find that models conditioned on the Taylor rule fundamentals with homogeneous coefficients without interest rate smoothing as well as PPP- and UIRP-based fundamentals offer better exchange rate predictability of the BRICS than the random walk model across the forecast horizons. In addition, constant parameter models offer superior forecasting ability relative to the time-varying parameter models. Our results are sensitive to the data sample, frequency and the choice of fundamentals captured in the predictive model of exchange rate.