An Economic Evaluation of Empirical Exchange Rate Models

43 Pages Posted: 6 Jun 2008

See all articles by Pasquale Della Corte

Pasquale Della Corte

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Ilias Tsiakas

University of Guelph

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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.

Keywords: Bayesian MCMC Estimation, Bayesian Model Averaging, Economic Value, Exchange Rates, Forward Premium, Monetary Fundamentals, Volatility

JEL Classification: F31, F37, G11

Suggested Citation

Della Corte, Pasquale and Sarno, Lucio and Tsiakas, Ilias, An Economic Evaluation of Empirical Exchange Rate Models. CEPR Discussion Paper No. DP6598. Available at SSRN: https://ssrn.com/abstract=1140527

Pasquale Della Corte

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London, SW7 2AZ
United Kingdom
+44(0)20 759 49331 (Phone)

HOME PAGE: http://sites.google.com/view/pasqualedellacorte

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Lucio Sarno (Contact Author)

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Ilias Tsiakas

University of Guelph ( email )

Department of Economics and Finance
University of Guelph
Guelph, Ontario N1G 2W1
Canada
5198244120 ext 53054 (Phone)
5197638497 (Fax)

HOME PAGE: http://www.uoguelph.ca/~itsiakas

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