DP4365 Exchange Rates and Fundamentals: Evidence on the Economic Value of Predictability

Author(s): Abhay Abhyankar, Lucio Sarno, Giorgio Valente
Publication Date: April 2004
Keyword(s): forecasting, foreign exchange, monetary fundamentals, optimal portfolio, parameter uncertainty
JEL(s): F31
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4365

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.