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Factor Model Forecasts of Exchange Rates

Author

Listed:
  • Nelson Mark

    (Department of Economics, University of Notre Dame)

Abstract

We construct factors from a cross section of exchange rates and use the idiosyncratic deviations from the factors to forecast. In a stylized data generating process, we show that such forecasts can be effective even if there is essentially no serial correlation in the univariate exchange rate processes. We apply the technique to a panel of bilateral U.S. dollar rates against 17 OECD countries. We forecast using factors, and using factors combined with any of fundamentals suggested by Taylor rule, monetary and purchasing power parity (PPP) models. For long horizon (8 and 12 quarter) forecasts, we tend to improve on the forecast of a ³no change² benchmark in the late (1999-2007) but not early (1987-1998) parts of our sample.

Suggested Citation

  • Nelson Mark, 2008. "Factor Model Forecasts of Exchange Rates," Working Papers 012, University of Notre Dame, Department of Economics, revised Jan 2012.
    • Handle: RePEc:nod:wpaper:012
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    File URL: http://www3.nd.edu/~tjohns20/RePEc/deendus/wpaper/012_rates.pdf
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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