Exchange rates and fundamentals: Forecasting with long maturity forward rates

Zsolt Darvas and Zoltán Schepp

Journal of International Money and Finance, 2024, vol. 143, issue C

Abstract: We show that in a popular model of exchange rate determination, the unobserved expected future exchange rate can be substituted with the observed forward exchange rate. This allows the derivation of a new error-correction forecasting model, which approximates the gap between the fundamental equilibrium exchange rate and the actual exchange rate with the long-maturity forward exchange rate. Our out-of-sample forecasting results for major currencies are unprecedented. The forecasting model is simple, easy to replicate, and the data we use are available in real time and not subject to revisions.

Keywords: Exchange rates; Error correction; Forecasting performance; Monetary model; Out-of-sample; Random walk (search for similar items in EconPapers)
JEL-codes: F31 F37 F41 G15 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:143:y:2024:i:c:s0261560624000548

DOI: 10.1016/j.jimonfin.2024.103067

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