Overreaction and underreaction to new information and the directional forecast of exchange rates

Andrei Semenov

International Review of Economics & Finance, 2024, vol. 96, issue PC

Abstract: Overreaction and underreaction to new information may cause, respectively, sequences and reversals in exchange rate returns. Empirical evidence is that the sign of the difference between the probabilities of a sequence and a reversal predicts the sign of the next day exchange rate return out-of-sample better than the random walk without drift model. Since the effect of overreaction of exchange rates to unexpected news dies out over longer time spans, the directional predictability becomes weaker for the weekly exchange rates. The trading strategy exploiting the directional predictability of the exchange rates generates tangible profits compared to the non-trading and buy-and-hold strategies.

Keywords: Directional predictability; Exchange rate return; Forecasting; Random walk (search for similar items in EconPapers)
JEL-codes: C53 F31 F37 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:96:y:2024:i:pc:s1059056024006683

DOI: 10.1016/j.iref.2024.103676

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