Factor Model Forecasts of Exchange Rates

Charles Engel, Nelson C. Mark, Kenneth D. West

NBER Working Paper No. 18382
Issued in September 2012
NBER Program(s):Asset Pricing Program, International Finance and Macroeconomics Program, Monetary Economics Program

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.

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Acknowledgments

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Document Object Identifier (DOI): 10.3386/w18382

Published: Charles Engel & Nelson C. Mark & Kenneth D. West, 2015. "Factor Model Forecasts of Exchange Rates," Econometric Reviews, Taylor & Francis Journals, vol. 34(1-2), pages 32-55, February. citation courtesy of

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