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A New Approach to Forecasting Exchange Rates

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Author Info

  • Kenneth W Clements

    (UWA Business School, The University of Western Australia)

  • Yihui Lan

    ()
    (UWA Business School, The University of Western Australia)

Abstract

Building on purchasing power parity theory, this paper proposes a new approach to forecasting exchange rates using the Big Mac data from The Economist magazine. Our approach is attractive in three aspects. Firstly, it uses easily-available Big Mac prices as input. These prices avoid several serious problems associated with broad price indexes, such as the CPI, that are used in conventional PPP studies. Secondly, this approach provides real-time exchange-rate forecasts at any forecast horizon. Such real-time forecasts can be made on a day-to-day basis if required, so that the forecasts are based on the most up-to-date information set. These high-frequency forecasts could be particularly appealing to decision makers who want up-to-date forecasts of exchange rates. Finally, as our forecasts are obtained through Monte Carlo simulation, estimation uncertainty is made explicit in our framework which provides the entire distribution of exchange rates, not just a single point estimate. A comparison of our forecasts with the random walk model shows that although the random walk is superior for very short horizons, our approach tends to dominate over the medium to longer term.

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Bibliographic Info

Paper provided by The University of Western Australia, Department of Economics in its series Economics Discussion / Working Papers with number 06-29.

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Length: 24 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:uwa:wpaper:06-29

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Keywords: Exchange-rate forecasting; Bic Mac prices; purchasing power parity; Monte Carlo simulation;

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References

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Cited by:
  1. Clements, Kenneth & Lan, Yihui & Roberts, John, 2008. "Exchange-rate economics for the resources sector," Resources Policy, Elsevier, vol. 33(2), pages 102-117, June.

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