Exchange Rates and Fundamentals: Evidence on the Economic Value of Predictability

48 Pages Posted: 26 May 2004

See all articles by Abhay Abhyankar

Abhay Abhyankar

University of Exeter Business School, University of Exeter

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR)

Date Written: April 2004

Abstract

A major puzzle in international finance is the inability of models based on monetary fundamentals to produce better out-of-sample forecasts of the nominal exchange rate than a naive random walk. While prior research has generally evaluated exchange rate forecasts using conventional statistical measures of forecast accuracy, in this Paper, we investigate whether there is any economic value to the predictive power of monetary fundamentals for the exchange rate. We estimate, using a framework that allows for parameter uncertainty, the economic and utility gains to an investor who manages a portfolio based on exchange rate forecasts from a monetary fundamentals model. In contrast to much previous research, we find that the economic value of the exchange rate forecasts implied by monetary fundamentals can be substantially greater than the economic value of forecasts obtained using a random walk across a range of horizons.

Keywords: Foreign exchange, monetary fundamentals, forecasting, parameter uncertainty, optimal portfolio

JEL Classification: F31

Suggested Citation

Abhyankar, Abhay and Sarno, Lucio and Valente, Giorgio, Exchange Rates and Fundamentals: Evidence on the Economic Value of Predictability (April 2004). CEPR Discussion Paper No. 4365. Available at SSRN: https://ssrn.com/abstract=549142

Abhay Abhyankar

University of Exeter Business School, University of Exeter ( email )

Streatham Court
Exeter, EX4 4PU
United Kingdom

Lucio Sarno (Contact Author)

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR) ( email )

One Pacific Place, 10th Floor
88 Queensway
Hong Kong
China

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