An Economic Evaluation of Empirical Exchange Rate Models

Posted: 8 Sep 2009

See all articles by Pasquale Della Corte

Pasquale Della Corte

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

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Ilias Tsiakas

University of Guelph

Multiple version iconThere are 2 versions of this paper

Date Written: September 2009

Abstract

This paper provides a comprehensive evaluation of the short-horizon predictive ability of economic fundamentals and forward premiums 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: (1) 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 that conditions on the forward premium with stochastic volatility innovations and (2) 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: F31, F37, G11

Suggested Citation

Della Corte, Pasquale and Sarno, Lucio and Tsiakas, Ilias, An Economic Evaluation of Empirical Exchange Rate Models (September 2009). The Review of Financial Studies, Vol. 22, Issue 9, pp. 3491-3530, 2009, Available at SSRN: https://ssrn.com/abstract=1468191 or http://dx.doi.org/hhn058

Pasquale Della Corte (Contact Author)

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

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
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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