Exchange Rate Forecasting on a Napkin

19 Pages Posted: 25 May 2018

See all articles by Michele Ca'Zorzi

Michele Ca'Zorzi

European Central Bank (ECB)

Michał Rubaszek

National Bank of Poland; Warsaw School of Economics (SGH)

Date Written: May 22, 2018

Abstract

This paper shows that there are two regularities in foreign exchange markets in advanced countries with flexible regimes. First, real exchange rates are mean-reverting, as implied by the Purchasing Power Parity model. Second, the adjustment takes place via nominal exchange rates. These features of the data can be exploited, even on the back of a napkin, to generate nominal exchange rate forecasts that outperform the random walk. The secret is to avoid estimating the pace of mean reversion and assume that relative prices are unchanged. Direct forecasting or panel data techniques are better than the random walk but fail to beat this simple calibrated model.

Keywords: exchange rates, forecasting, Purchasing Power Parity, panel data, mean reversion

JEL Classification: C32, F31, F37, F41

Suggested Citation

Ca' Zorzi, Michele and Rubaszek, Michal, Exchange Rate Forecasting on a Napkin (May 22, 2018). ECB Working Paper No. 2151. Available at SSRN: https://ssrn.com/abstract=3183690

Michele Ca' Zorzi (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Michal Rubaszek

National Bank of Poland ( email )

00-919 Warsaw
Poland

Warsaw School of Economics (SGH) ( email )

aleja Niepodleglosci 162
PL-Warsaw, 02-554
Poland

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