Forecasting Exchange Rates under Parameter and Model Uncertainty
46 Pages Posted: 29 Sep 2014 Last revised: 9 Dec 2015
Date Written: September 25, 2014
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
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