Which Fundamentals Drive Exchange Rates? A Cross-Sectional Perspective

48 Pages Posted: 19 May 2011 Last revised: 5 Apr 2013

See all articles by Lucio Sarno

Lucio Sarno

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

Maik Schmeling

Goethe University Frankfurt - Department of Finance; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: April 4, 2013

Abstract

Standard present-value models suggest that exchange rates are driven by expected future fundamentals, implying that current exchange rates contain predictive information about future fundamentals. We test the validity of this key empirical prediction of present-value models in a sample of 35 currency pairs ranging from 1900 to 2009. Employing a variety of tests, we find that exchange rates have strong and significant predictive power for nominal fundamentals (inflation, money balances, nominal GDP), whereas predictability of real fundamentals and risk premia is much weaker and largely confined to the post-Bretton Woods era. Overall, we uncover ample evidence that future macro fundamentals drive current exchange rates.

Keywords: Exchange rates, economic fundamentals, forecasting, present value model

JEL Classification: F31, G10

Suggested Citation

Sarno, Lucio and Schmeling, Maik, Which Fundamentals Drive Exchange Rates? A Cross-Sectional Perspective (April 4, 2013). Available at SSRN: https://ssrn.com/abstract=1835747 or http://dx.doi.org/10.2139/ssrn.1835747

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

Maik Schmeling

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60323
Germany

HOME PAGE: http://sites.google.com/site/maikschmeling/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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