RFS Advance Access published online on June 13, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn058
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An Economic Evaluation of Empirical Exchange Rate Models
University of Warwick
University of Warwick, AXA Investment Managers, and Centre for Economic Policy Research (CEPR)
University of Warwick
Address correspondence to Lucio Sarno, Finance Group, Warwick Business School, University of Warwick, Coventry CV4 7AL, UK; lucio.sarno{at}wbs.ac.uk.
Other authors: Pasquale Della Corte: pasquale.dellacorte{at}wbs.ac.uk.
Ilias Tsiakas: ilias.tsiakas{at}wbs.ac.uk.
JEL Classification: F31, F37, G11
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Abstract |
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This paper provides a comprehensive evaluation of the short-horizon predictive ability of economic fundamentals and forward premiums 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: (1) 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 that conditions on the forward premium with stochastic volatility innovations and (2) strategies based on combined forecasts yield large economic gains over the random walk benchmark. These two results are robust to reasonably high transaction costs.
This paper was partly written while Lucio Sarno was a visiting scholar at the International Monetary Fund, and Norges Bank. The authors are indebted for useful conversations or constructive comments to Joel Hasbrouck (editor), two anonymous referees, David Backus, Luc Bauwens, Sid Chib, Frank Diebold, Massimo Guidolin, Rich Lyons, Michael Moore, Roel Oomen, Carol Osler, Dagfinn Rime, Simon van Norden, Arnold Zellner as well as to participants at the 2007 INFER conference keynote speech; the 2007 workshop on "Trading Strategies and Financial Market Inefficiency" at Imperial College London; the 2007 seminar on Bayesian Inference in Econometrics and Statistics; the 2007 Royal Economic Society meetings; the 2006 European Science Foundation workshop on FX Markets at the University of Warwick; the 2006 European meetings of the Econometric Society; the 2006 Northern Finance Association meetings; the 2006 EC Conference on the "Econometrics of Monetary Policy and Financial Decision Making"; and seminars at the European Central Bank and the International Monetary Fund.