Forecasting Exchange Rates under Parameter and Model Uncertainty

Abstract

We introduce a forecasting method that closely matches the econometric properties required by the theory of exchange rate prediction. Our approach formally models (i) when (and if) predictor variables enter or leave a regression model, (ii) the degree of parameter instability, (iii) the (potentially) rapidly changing relevance of regressors, and (iv) the appropriate shrinkage intensity over time. We consider (short-term) forecasting of six major US dollar exchange rates using a standard set of macro fundamentals. Our results indicate the importance of shrinkage and flexible model selection criteria to avoid poor forecasting results.

Keywords: Shrinkage; Time-varying parameter models; Exchange rate forecasting

JEL Classification: F31, F37, G17