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An Economic Evaluation of Empirical Exchange Rate Models

Lucio Sarno, Pasquale Della Corte and Ilias Tsiakas

No 6598, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper provides a comprehensive evaluation of the short-horizon predictive ability of economic fundamentals and forward premia on monthly exchange rate returns in a framework that allows for volatility timing. We implement Bayesian methods for estimation and ranking of a set of empirical exchange rate models, and construct combined forecasts based on Bayesian Model Averaging. More importantly, we assess the economic value of the in-sample and out-of-sample forecasting power of the empirical models, and find two key results: (i) a risk averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on the random walk model to one which conditions on the forward premium with stochastic volatility innovations; and (ii) strategies based on combined forecasts yield large economic gains over the random walk benchmark. These two results are robust to reasonably high transaction costs.

Keywords: Exchange rates; Economic value; Forward premium; Monetary fundamentals; Volatility; Bayesian mcmc estimation; Bayesian model averaging (search for similar items in EconPapers)
JEL-codes: F31 F37 G11 (search for similar items in EconPapers)
Date: 2007-12
New Economics Papers: this item is included in nep-cba, nep-ecm and nep-ifn
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Citations: View citations in EconPapers (66)

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Journal Article: An Economic Evaluation of Empirical Exchange Rate Models (2009) Downloads
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