DP8045 The Predictive Information Content of External Imbalances for Exchange Rate Returns: How Much Is It Worth?

Author(s): Pasquale Della Corte, Lucio Sarno, Giulia Sestieri
Publication Date: October 2010
Keyword(s): foreign exchange, fundamentals, global imbalances, predictability
JEL(s): F31, F37, G15
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8045

This paper examines the exchange rate predictability stemming from the equilibrium model of international financial adjustment developed by Gourinchas and Rey (2007). Using predictive variables that measure cyclical external imbalances for country pairs, we assess the ability of this model to forecast out-of-sample four major US dollar exchange rates using various economic criteria of model evaluation. The analysis shows that the model provides economic value to a risk-averse investor, delivering substantial utility gains when switching from a portfolio strategy based on the random walk benchmark to one that conditions on cyclical external imbalances.