Forecasting Exchange Rates: An Investor Perspective

40 Pages Posted: 22 May 2013

See all articles by Michael Melvin

Michael Melvin

University of California, San Diego (UCSD) - Rady School of Management; CESifo (Center for Economic Studies and Ifo Institute)

John Prins

BlackRock, Inc

Duncan D. Shand

BlackRock, Inc

Date Written: May 21, 2013

Abstract

The popular scholarly exercise of evaluating exchange rate forecasting models relative to a random walk was stimulated by the well-cited Meese and Rogoff (1983) paper. Practitioners who construct quantitative models for trading exchange rates approach forecasting from a different perspective. Rather than focus on forecast errors for bilateral exchange rates, as in the Meese-Rogoff case, we present what is required for constructing a successful trading model. To provide more perspective, a particular approach to quantitative modeling is presented that incorporates return forecasts, a risk model, and a transaction cost constraint in an optimization framework. Since beating a random walk is not a useful evaluation metric for currency investing, we discuss the use of benchmarks and conclude that performance evaluation in currencies is much more problematic than in equity markets due to the lack of a passive investment strategy and the multitude of alternative formulations of well-known currency style factors. We then provide analytical tools that can be useful in evaluating currency manager skill in terms of portfolio tilts and timing. Finally, we examine how conditioning information can be employed to enhance timing skill in trading generic styles like the carry trade. Such information can be valuable in reducing the duration and magnitude of portfolio drawdowns.

Keywords: exchange rate forecasting, forecast evaluation, conditioners, quantitative models, benchmarks

JEL Classification: C520, C530, C580, F310, F370, G150, G170

Suggested Citation

Melvin, Michael and Prins, John and Shand, Duncan D., Forecasting Exchange Rates: An Investor Perspective (May 21, 2013). CESifo Working Paper Series No. 4238. Available at SSRN: https://ssrn.com/abstract=2267717

Michael Melvin (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

John Prins

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

Duncan D. Shand

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

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