Foreign Currency Forecasting: What Can Stock and Bond Markets Tell Us?

Abstract

This paper provides a comprehensive statistical and economic evidence on the forecasting power of local-currency equity and bond returns in predicting exchange rate returns. We first construct out-of-sample (OOS) forecasts using various model specifications of equity and bond returns, and assess their statistical accuracy against the naïve random walk (RW) model. Next, we test their economic value by designing a trading strategy based on the sign of our OOS forecasts. Using a sample of 28 countries, we find three key results: (1) our in-sample forecasts show that all the slope estimates of our predictive regressions are significant, indicating that the RW model is misspecified; (2) the statistical accuracy criteria suggest that our OOS forecasts outperform the RW model; and (3) our trading strategies, that use stock and bond returns, generate high and significant Sharpe ratios which are uncorrelated with the traditional risk factors and other popular determinants of currency returns.

Keywords: exchange rates, out of sample predictability, equity returns, bond market returns, financial crisis

JEL Classification: G15, G17, F31