DP15305 Exchange Rate Prediction with Machine Learning and a Smart Carry Trade Portfolio
|Author(s):||Ilias Filippou, David Rapach, Mark P Taylor, Guofu Zhou|
|Publication Date:||September 2020|
|Keyword(s):||carry trade, deep neural network, Elastic Net, exchange rate predictability|
|JEL(s):||C45, F31, F37, G11, G12, G15|
|Programme Areas:||International Macroeconomics and Finance|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=15305|
We establish the out-of-sample predictability of monthly exchange rate changes via machine learning techniques based on 70 predictors capturing country characteristics, global variables, and their interactions. To guard against overfitting, we use the elastic net to estimate a high-dimensional panel predictive regression and find that the resulting forecast consistently outperforms the naive no-change benchmark, which has proven difficult to beat in the literature. The forecast also markedly improves the performance of a carry trade portfolio, especially during and after the global financial crisis. When we allow for more complex deep learning models, nonlinearities do not appear substantial in the data.