Forecasting exchange rates of major currencies with long maturity forward rates

Darvas, Zsolt and Schepp, Zoltán (2020) Forecasting exchange rates of major currencies with long maturity forward rates. Working Paper. Corvinus University of Budapest, Budapest.

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This paper presents unprecedented exchange rate forecasting results based upon a new model which approximates the gap between the fundamental equilibrium exchange rate and the actual exchange rate with the long-maturity forward exchange rate. The theoretical derivation of our forecasting equation is consistent with the monetary model of exchange rates. Our model outperforms the random walk in out-of-sample forecasting of twelve major currency pairs in both short and long horizons forecasts for the 1990-2020 period. The results are robust for all sub-periods with the exception of years around the collapse of Lehman Brothers in September 2008. Our results are robust to alternative model specifications, single equation and panel estimation, recursive and rolling estimation, and alternate data construction methods. The model performs better when the long-maturity forward exchange rate is assumed to be stationary as opposed to assuming non-stationarity. The improvement in forecast accuracy of our model is economically and statistically significant for almost all exchange rate series. The model is simple, linear, easy to replicate, and the data we use are available in real time and not subject to revisions.

Item Type:Monograph (Working Paper)
Series Name:Corvinus Economics Working Papers - CEWP
Series Number / Identification Number:2020/01
Uncontrolled Keywords:exchange rate, error correction, forecasting performance, monetary model, out-of-sample, random walk
JEL classification:F31 - Foreign Exchange
F37 - International Finance Forecasting and Simulation: Models and Applications
Subjects:Mathematics, Econometrics
ID Code:5665
Deposited By: Ádám Hoffmann
Deposited On:03 May 2020 18:56
Last Modified:03 May 2020 18:56

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