On the Sources of Uncertainty in Exchange Rate Predictability

Abstract

In a unified framework, we examine four sources of uncertainty in exchange rate forecasting models: (i) random variations in the data, (ii) estimation uncertainty, (iii) uncertainty about the degree of time-variation in coefficients, and (iv) uncertainty regarding the choice of the predictor. We find that models which embed a high-degree of coefficient variability yield forecast improvements at horizons beyond 1-month. At the 1-month horizon, and apart from the standard variance implied by unpredictable fluctuations in the data, the second and third sources of uncertainty listed above are key obstructions to predictive ability. The uncertainty regarding the choice of the predictors is negligible.

Keywords: Exchange rate forecasting, Instabilities, Time-varying parameter models, Bayesian model selection, Forecast combination

JEL Classification: C53, C55, E44, F37, G11