Forecasting the Colombian Exchange Rate: Capital Adjustments and Politics vs. Traditional IRP, Trade Adjustments and Random Walk Frameworks

Very few forecasting studies have been made for the Colombian exchange rate. In this paper I try to show what variables actually affect and determine the exchange rate in Colombia. I study 2 different models for forecasting the exchange rate and asses their forecasting ability by comparing them to 3 traditionally used benchmark models. The first model relies on the idea that a current account deficit and negative net foreign assets imply a future increase in either net exports or foreign portfolio returns which, in turn, imply an exchange rate devaluation. The second model tries to capture the effect of the country’s political situation and its economic agents’ perception of the current state of economic fundamentals, on future exchange rate movements. I will show that the second model performs well for short term horizons and that the first model is out-performed by at least one of the remaining models for every single forecasting horizon. The Colombian case is particularly interesting since there are many untraditional factors, such as social instability and illegality, which may affect the exchange rate. In the paper I will also show evidence of the influence of these untraditional factors on the exchange rate using the forecast results of the models studied