Exchange rates and fundamentals : forecasting with long maturity forward rates

Darvas, Zsolt ORCID: https://orcid.org/0000-0001-9312-929X and Schepp, Zoltán ORCID: https://orcid.org/0009-0002-7066-6134 (2024) Exchange rates and fundamentals : forecasting with long maturity forward rates. Journal of International Money and Finance, 143 . DOI 10.1016/j.jimonfin.2024.103067

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Official URL: https://doi.org/10.1016/j.jimonfin.2024.103067

Abstract

We show that in a popular model of exchange rate determination, the unobserved expected future exchange rate can be substituted with the observed forward exchange rate. This allows the derivation of a new error-correction forecasting model, which approximates the gap between the fundamental equilibrium exchange rate and the actual exchange rate with the long-maturity forward exchange rate. Our out-of-sample forecasting results for major currencies are unprecedented. The forecasting model is simple, easy to replicate, and the data we use are available in real time and not subject to revisions.

Item Type:

Article

Uncontrolled Keywords:

Exchange rates ; 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
F41 - Open Economy Macroeconomics
G15 - International Financial Markets

Divisions:

Institute of Economics

Subjects:

Finance

Funders:

Hungarian Scientific Research Fund, TÁMOP, National Research, Development and Innovation Fund of Hungary

Projects:

K 61221, 4.2.2.C-11/1/KONV-2012-0005, TKP2021-NKTA-19

DOI:

10.1016/j.jimonfin.2024.103067

ID Code:

10987