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Exchange rate forecasting on a napkin

Author

Listed:
  • Michele Ca' Zorzi

    (European Central Bank)

  • Micha􏰀l Rubaszek

    (SGH Warsaw School of Economics)

Abstract

This paper shows that there are two regularities in foreign exchange markets in advanced countries with flexible regimes. First, real exchange rates are mean-reverting, as implied by the Purchasing Power Parity model. Second, the adjustment takes place via nominal exchange rates. These features of the data can be exploited, even on the back of a napkin, to generate nominal exchange rate forecasts that outperform the random walk. The secret is to avoid estimating the pace of mean reversion and assume that relative prices are unchanged. Direct forecasting or panel data techniques are better than the random walk but fail to beat this simple calibrated model.

Suggested Citation

  • Michele Ca' Zorzi & Micha􏰀l Rubaszek, 2018. "Exchange rate forecasting on a napkin," GRU Working Paper Series GRU_2018_025, City University of Hong Kong, Department of Economics and Finance, Global Research Unit.
    • Handle: RePEc:cth:wpaper:gru_2018_025
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    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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