Superior Predictability of American Factors of the Won/Dollar Real Exchange Rate

Utilizing an array of data dimensionality reduction methods, we estimate latent common factors for the Won/Dollar real exchange rate from a large panel of economic predictors of the U.S. and Korea. We demonstrate superior out-of-sample predictability of our factor augmented forecasting models relative to conventional models when we utilize factors obtained from U.S. economic variables, while the Korean factors fail to enhance predictability. Our models perform better at longer horizons when the American real activity factors are employed, whereas the American nominal/financial market factors help improve short-run prediction accuracy. The UIP-based global factors with the dollar as numeraire overall perform well, while the PPP and RIRP factors play a limited role in forecasting the Won/Dollar exchange rate.