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An Economic Evaluation of Empirical Exchange Rate Models

  • Della Corte, Pasquale
  • Sarno, Lucio
  • Tsiakas, Ilias

This paper provides a comprehensive evaluation of the short-horizon predictive ability of economic fundamentals and forward premia on monthly exchange rate returns in a framework that allows for volatility timing. We implement Bayesian methods for estimation and ranking of a set of empirical exchange rate models, and construct combined forecasts based on Bayesian Model Averaging. More importantly, we assess the economic value of the in-sample and out-of-sample forecasting power of the empirical models, and find two key results: (i) a risk averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on the random walk model to one which conditions on the forward premium with stochastic volatility innovations; and (ii) strategies based on combined forecasts yield large economic gains over the random walk benchmark. These two results are robust to reasonably high transaction costs.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6598.

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Date of creation: Dec 2007
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Handle: RePEc:cpr:ceprdp:6598
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