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The Predictive Information Content of External Imbalances for Exchange Rate Returns: How Much Is It Worth?

  • Della Corte, P.
  • Sarno, L.
  • Sestieri, G.

This paper examines the exchange rate predictability stemming from the equilibrium model of international financial adjustment developed by Gourinchas and Rey (2007). Using predictive variables that measure cyclical external imbalances for country pairs, we assess the ability of this model to forecast out-of-sample four major US dollar exchange rates using various economic criteria of model evaluation. The analysis shows that the model provides economic value to a risk-averse investor, delivering substantial utility gains when switching from a portfolio strategy based on the random walk benchmark to one that conditions on cyclical external imbalances.

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Paper provided by Banque de France in its series Working papers with number 313.

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Length: 41 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:bfr:banfra:313
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Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS

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  9. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  10. Francis X. Diebold & Robert S. Mariano, 1994. "Comparing Predictive Accuracy," NBER Technical Working Papers 0169, National Bureau of Economic Research, Inc.
  11. Barbara Rossi, 2005. "Are Exchange Rates Really Random Walks? Some Evidence Robust to Parameter Instability," International Finance 0503006, EconWPA.
  12. Goncalves, Silvia & White, Halbert, 2005. "Bootstrap Standard Error Estimates for Linear Regression," Journal of the American Statistical Association, American Statistical Association, vol. 100, pages 970-979, September.
  13. Elliott, Graham & ITO, TAKATOSHI, 1998. "Heterogeneous Expectations and Tests of Efficiency in the Yen/Dollar Forward Exchange Rate Market," University of California at San Diego, Economics Working Paper Series qt5wm0q8mz, Department of Economics, UC San Diego.
  14. Della Corte, Pasquale & Sarno, Lucio & Thornton, Daniel L, 2007. "The Expectation Hypothesis of the Term Structure of Very Short-Term Rates: Statistical Tests and Economic Value," CEPR Discussion Papers 6445, C.E.P.R. Discussion Papers.
  15. Q. Farooq Akram, & Dagfinn Rime & Lucio Sarno, 2005. "Arbitrage in the foreign exchange market: Turning on the microscope," Working Paper 2005/12, Norges Bank.
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  18. Dimitris Politis & Halbert White, 2004. "Automatic Block-Length Selection for the Dependent Bootstrap," Econometric Reviews, Taylor & Francis Journals, vol. 23(1), pages 53-70.
  19. Rossi, Barbara, 2002. "Testing Long-horizon Predictive Ability with High Persistence, and the Meese-Rogoff Puzzle," Working Papers 02-10, Duke University, Department of Economics.
  20. Robert Z. Aliber & Bhagwan Chowdhry & Shu Yan, 2003. "Some Evidence that a Tobin Tax on Foreign Exchange Transactions May Increase Volatility," Review of Finance, Springer, vol. 7(3), pages 481-510.
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  23. Della Corte, Pasquale & Sarno, Lucio & Tsiakas, Ilias, 2007. "An Economic Evaluation of Empirical Exchange Rate Models," CEPR Discussion Papers 6598, C.E.P.R. Discussion Papers.
  24. Kenneth S. Rogoff & Vania Stavrakeva, 2008. "The Continuing Puzzle of Short Horizon Exchange Rate Forecasting," NBER Working Papers 14071, National Bureau of Economic Research, Inc.
  25. West, K.D., 1994. "Asymptotic Inference About Predictive Ability," Working papers 9417, Wisconsin Madison - Social Systems.
  26. Ingrid M. Werner, 2003. "Comment on `Some Evidence that a Tobin Tax on Foreign Exchange Transactions may Increase Volatility'," Review of Finance, Springer, vol. 7(3), pages 511-514.
  27. Jeff Fleming, 2001. "The Economic Value of Volatility Timing," Journal of Finance, American Finance Association, vol. 56(1), pages 329-352, 02.
  28. Yufeng Han, 2006. "Asset Allocation with a High Dimensional Latent Factor Stochastic Volatility Model," Review of Financial Studies, Society for Financial Studies, vol. 19(1), pages 237-271.
  29. Kilian, Lutz, 1999. "Exchange Rates and Monetary Fundamentals: What Do We Learn from Long-Horizon Regressions?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(5), pages 491-510, Sept.-Oct.
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