Kouwenberg, R., Markiewicz, A., Verhoeks, R. and Zwinkels, R. (2017). Model Uncertainty and Exchange Rate Forecasting Journal of Financial and Quantitative Analysis, 52(1):341--363.
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Affiliated authors
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Publication year2017
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JournalJournal of Financial and Quantitative Analysis
Exchange rate models with uncertain and incomplete information predict that investors focus on a small set of fundamentals that changes frequently over time. We design a model selection rule that captures the current set of fundamentals that best predicts the exchange rate. Out-of-sample tests show that the forecasts made by this rule significantly beat a random walk for 5 out of 10 currencies. Furthermore, the currency forecasts generate meaningful investment profits. We demonstrate that the strong performance of the model selection rule is driven by time-varying weights attached to a small set of fundamentals, in line with theory.