Model Uncertainty and Exchange Rate Forecasting

52 Pages Posted: 9 Jul 2013 Last revised: 1 Feb 2016

See all articles by Roy Kouwenberg

Roy Kouwenberg

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Mahidol University - College of Management

Agnieszka Markiewicz

Erasmus University Rotterdam (EUR); Tinbergen Institute

Ralph Verhoeks

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Remco C. J. Zwinkels

Vrije Universiteit Amsterdam; Tinbergen Institute - Tinbergen Institute Amsterdam (TIA)

Date Written: November 13, 2013

Abstract

We propose a theoretical framework of exchange rate behavior where investors focus on a subset of economic fundamentals. We find that any adjustment in the set of predictors used by investors leads to changes in the relation between the exchange rate and fundamentals. We test the validity of this framework via a backward elimination rule which captures the current set of fundamentals that best predicts the exchange rate. Out-of-sample forecasting tests show that the backward elimination rule significantly beats the random walk for four out of five currencies in our sample. Further, the currency forecasts generate economically meaningful investment profits.

Keywords: exchange rate forecasting, model uncertainty, model averaging

JEL Classification: F31, F41, E44

Suggested Citation

Kouwenberg, Roy R. P. and Markiewicz, Agnieszka and Verhoeks, Ralph and Zwinkels, Remco C.J., Model Uncertainty and Exchange Rate Forecasting (November 13, 2013). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2291394 or http://dx.doi.org/10.2139/ssrn.2291394

Roy R. P. Kouwenberg

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

HOME PAGE: http://people.few.eur.nl/kouwenberg

Mahidol University - College of Management ( email )

69 Vipawadee Rangsit Road
Bangkok, 10400
Thailand

HOME PAGE: http://www.cmmu.mahidol.ac.th/main/faculty/aroy.asp

Agnieszka Markiewicz

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Ralph Verhoeks

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

Remco C.J. Zwinkels (Contact Author)

Vrije Universiteit Amsterdam ( email )

De Boelelaan 1105
Amsterdam, NL-1081HV
Netherlands
+31 20 59 85220 (Phone)

HOME PAGE: http://research.vu.nl/en/persons/remco-zwinkels

Tinbergen Institute - Tinbergen Institute Amsterdam (TIA) ( email )

Gustav Mahlerplein 117
Amsterdam, 1082 MS
Netherlands

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