Exchange Rates and Fundamentals: Footloose or Evolving Relationship?

43 Pages Posted: 5 Jun 2008

See all articles by Lucio Sarno

Lucio Sarno

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

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR)

Date Written: January 2008

Abstract

Using novel real-time data on a broad set of economic fundamentals for five major US dollar exchange rates over the recent float, we employ a predictive procedure that allows the relationship between exchange rates and fundamentals to evolve over time in a very general fashion. Our key findings are that: (i) the well-documented weak out-of-sample predictive ability of exchange rate models may be caused by poor performance of model-selection criteria, rather than lack of information content in the fundamentals; (ii) the difficulty of selecting the best predictive model is largely due to frequent shifts in the set of fundamentals driving exchange rates, which can be interpreted as reflecting swings in market expectations over time. However, the strength of the link between exchange rates and fundamentals is different across currencies.

Keywords: Economic fundamentals, exchange rates, forecasting

JEL Classification: F31, G10

Suggested Citation

Sarno, Lucio and Valente, Giorgio, Exchange Rates and Fundamentals: Footloose or Evolving Relationship? (January 2008). , Vol. , pp. -, 2008. Available at SSRN: https://ssrn.com/abstract=1140567

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

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR) ( email )

One Pacific Place, 10th Floor
88 Queensway
Hong Kong
China

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