Handbook of Exchange Rates

8.7 Conclusion

Thirty years of empirical research in international finance has attempted to resolve whether exchange rates are predictable. Most of this literature uses statistical criteria for OOS tests of the null of the RW representing no predictability against the alternative of linear models that depend on economic fundamentals. The results of these studies are specific to, among other things, the empirical model and the exchange rate series. The emerging literature has moved in a different direction by providing an economic evaluation of predictability. This second line of research takes the view of an investor who builds a dynamic asset allocation strategy that depends on the forecasts from a set of empirical exchange rate models. The results of these studies are also specific to the empirical model, but instead of providing results for one exchange rate at a time, they evaluate predictability by looking at the performance of dynamically rebalanced portfolios. Finally, there is a third strand of empirical work that forms ex-ante combined forecasts from a set of individual empirical models. The results of these studies are not particular to an empirical model but rather relate to forecast combinations that account for model uncertainty.

This chapter reviews and connects these three loosely related literatures. We illustrate the statistical and economic methodologies by estimating a set of widely used empirical exchange rate models using monthly returns from nine major USD ...