Factor Model Forecasts of Exchange Rates

33 Pages Posted: 15 Sep 2012 Last revised: 25 Mar 2022

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Nelson C. Mark

University of Notre Dame - Department of Economics and Econometrics; National Bureau of Economic Research (NBER)

Kenneth D. West

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: September 2012

Abstract

We construct factors from a cross section of exchange rates and use the idiosyncratic deviations from the factors to forecast. In a stylized data generating process, we show that such forecasts can be effective even if there is essentially no serial correlation in the univariate exchange rate processes. We apply the technique to a panel of bilateral U.S. dollar rates against 17 OECD countries. We forecast using factors, and using factors combined with any of fundamentals suggested by Taylor rule, monetary and purchasing power parity (PPP) models. For long horizon (8 and 12 quarter) forecasts, we tend to improve on the forecast of a "no change" benchmark in the late (1999-2007) but not early (1987-1998) parts of our sample.

Suggested Citation

Engel, Charles M. and Mark, Nelson Chung and West, Kenneth D., Factor Model Forecasts of Exchange Rates (September 2012). NBER Working Paper No. w18382, Available at SSRN: https://ssrn.com/abstract=2147093

Charles M. Engel (Contact Author)

University of Wisconsin - Madison - Department of Economics ( email )

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Nelson Chung Mark

University of Notre Dame - Department of Economics and Econometrics ( email )

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National Bureau of Economic Research (NBER)

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Kenneth D. West

University of Wisconsin - Madison - Department of Economics ( email )

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608-262-2033 (Fax)

National Bureau of Economic Research (NBER) ( email )

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