Working Paper: NBER ID: w23726
Authors: Ryan Greenaway-McGrevy; Donggyu Sul; Nelson Mark; Jyh-Lin Wu
Abstract: Using recently developed model selection procedures, we determine that exchange rate returns are driven by a two-factor model. We identify them as a dollar factor and a euro factor. Exchange rates are thus driven by global, US, and Euro-zone stochastic discount factors. The identified factors can also be given a risk-based interpretation. Identification motivates multilateral models for bilateral exchange rates. Out-of-sample forecast accuracy of empirically identified multilateral models dominate the random walk and a bilateral purchasing power parity fundamentals prediction model. 24-month ahead forecast accuracy of the multilateral model dominates those of a principal components forecasting model.
Keywords: exchange rates; common factors; stochastic discount factors; forecasting
JEL Codes: F31; F37
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| dollar factor (F31) | exchange rate returns (F31) |
| euro factor (F36) | exchange rate returns (F31) |
| dollar factor (F31) | commodity-exporting countries' currencies (F31) |
| euro factor (F36) | European currencies (F36) |
| dollar and euro factors (F31) | exchange rate returns (F31) |