Della Corte, Pasquale, Sarno, Lucio and Tsiakas, Ilias (2007) An economic evaluation of empirical exchange rate models. Discussion Paper. London: Centre for Economic Policy Research (Great Britain). (Discussion paper (Centre for Economic Policy Research (Great Britain))).

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Abstract

This paper provides a comprehensive evaluation of the short-horizon predictive ability of economic fundamentals and forward premia on monthly exchange rate returns in a framework that allows for volatility timing. We implement Bayesian methods for estimation and ranking of a set of empirical exchange rate models, and construct combined forecasts based on Bayesian Model Averaging. More importantly, we assess the economic value of the in-sample and out-of-sample forecasting power of the empirical models, and find two key results: (i) a risk averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on the random walk model to one which conditions on the forward premium with stochastic volatility innovations; and (ii) strategies based on combined forecasts yield large economic gains over the random walk benchmark. These two results are robust to reasonably high transaction costs.

Item Type:	Working or Discussion Paper (Discussion Paper)
Subjects:	H Social Sciences > HG Finance
Divisions:	Faculty of Social Sciences > Warwick Business School
Library of Congress Subject Headings (LCSH):	Foreign exchange rates -- Mathematical models, Bayesian statistical decision theory, Economic forecasting, Risk perception
Series Name:	Discussion paper (Centre for Economic Policy Research (Great Britain))
Publisher:	Centre for Economic Policy Research (Great Britain)
Place of Publication:	London
Date:	December 2007
Number:	No.659
Number of Pages:	43
Status:	Not Peer Reviewed
Access rights to Published version:	Open Access
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URI:	http://wrap.warwick.ac.uk/id/eprint/1713

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