Working Paper: NBER ID: w18382
Authors: Charles Engel; Nelson C. Mark; Kenneth D. West
Abstract: We construct factors from a cross section of exchange rates and use the idiosyncratic deviations from the factors to forecast. In a stylized data generating process, we show that such forecasts can be effective even if there is essentially no serial correlation in the univariate exchange rate processes. We apply the technique to a panel of bilateral U.S. dollar rates against 17 OECD countries. We forecast using factors, and using factors combined with any of fundamentals suggested by Taylor rule, monetary and purchasing power parity (PPP) models. For long horizon (8 and 12 quarter) forecasts, we tend to improve on the forecast of a "no change" benchmark in the late (1999-2007) but not early (1987-1998) parts of our sample.
Keywords: Exchange Rates; Forecasting; Factor Models; Panel Data
JEL Codes: C53; C58; F37; G17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deviation of exchange rates from a measure of central tendency (F31) | subsequent movements in those exchange rates (F31) |
| factor model predictions (C38) | actual exchange rate movements (F31) |
| factor model performance (C52) | predictive accuracy (C52) |
| factor model performance (C52) | performance not significantly surpassing no-change forecast (G17) |