Exchange Rates and Unobservable Fundamentals: A New Approach to Out-of-Sample Forecasting

48 Pages Posted: 10 Apr 2016 Last revised: 10 Nov 2016

See all articles by Dennis Wellmann

Dennis Wellmann

Macquarie University

Stefan Trück

Macquarie University Sydney - Department of Applied Finance and Actuarial Studies; Financial Research Network (FIRN); Centre for International Finance and Regulation (CIFR); Macquarie University, Macquarie Business School

Date Written: October 1, 2016

Abstract

Traditional exchange rate models are based on differences in macroeconomic fundamentals. However, despite being well grounded in economic theory they have a rather poor out-of sample forecasting record. This empirical failure may be a result of the overly restrictive choice of macroeconomic fundamentals. We suggest using the empirical sovereign yield spread level and slope as proxies of the market's expectations for current and future fundamentals and find promising results when we investigate the forecasting accuracy of these variables. Using the yield spread level and slope as a set of unobservable fundamentals, our model outperforms traditional exchange rate models for most considered currencies and horizons. It is also superior to a random walk in terms of direction of change forecasts and profitability.

Keywords: Macroeconomic Fundamentals, Exchange Rate Forecasting, Financial Variables

JEL Classification: E43, F31, F37, G15, G17

Suggested Citation

Wellmann, Dennis and Trueck, Stefan, Exchange Rates and Unobservable Fundamentals: A New Approach to Out-of-Sample Forecasting (October 1, 2016). FIRN Research Paper No. 2760772, Available at SSRN: https://ssrn.com/abstract=2760772 or http://dx.doi.org/10.2139/ssrn.2760772

Dennis Wellmann

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

Stefan Trueck (Contact Author)

Macquarie University Sydney - Department of Applied Finance and Actuarial Studies ( email )

North Ryde
Sydney, New South Wales 2109
Australia
61298508483 (Phone)
61298508483 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Centre for International Finance and Regulation (CIFR) ( email )

Level 7, UNSW CBD Campus
1 O'Connell Street
Sydney, NSW 2000
Australia

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
279
Abstract Views
1,344
Rank
199,434
PlumX Metrics