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Exchange rate predictability

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Abstract

The main goal of this article is to provide an answer to the question: "Does anything forecast exchange rates, and if so, which variables?". It is well known that exchange rate fluctuations are very difficult to predict using economic models, and that a random walk forecasts exchange rates better than any economic model (the Meese and Rogoff puzzle). However, the recent literature has identified a series of fundamentals/methodologies that claim to have resolved the puzzle. This article provides a critical review of the recent literature on exchange rate forecasting and illustrates the new methodologies and fundamentals that have been recently proposed in an up- to-date, thorough empirical analysis. Overall, our analysis of the literature and the data suggests that the answer to the question: "Are exchange rates predictable?" is, "It depends" -on the choice of predictor, forecast horizon, sample period, model, and forecast evaluation method. Predictability is most apparent when one or more of the following hold: the predictors are Taylor rule or net foreign assets, the model is linear, and a small number of parameters are estimated. The toughest benchmark is the random walk without drift.

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  • Barbara Rossi, 2013. "Exchange rate predictability," Economics Working Papers 1369, Department of Economics and Business, Universitat Pompeu Fabra.
  • Handle: RePEc:upf:upfgen:1369
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    Keywords

    Exchange Rates; Forecasting; Instability; Forecast Evaluation.;
    All these keywords.

    JEL classification:

    • F3 - International Economics - - International Finance
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling

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