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An economic evaluation of empirical exchange rate models

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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)) (No.659).

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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
Official Date: December 2007
Dates:
DateEvent
December 2007Published
Number: No.659
Number of Pages: 43
Institution: University of Warwick
Status: Not Peer Reviewed
Access rights to Published version: Open Access

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