Forecasting exchange rates of major currencies with long maturity forward rates

This paper presents unprecedented exchange rate forecasting results based upon a new model which approximates the gap between the fundamental equilibr

Publishing date: 02 April 2020
Issue number: 02/2020
Authors: Zsolt Darvas Zoltán Schepp

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A revised version of this working paper was published in the Journal of International Money and Finance in 2024.

The theoretical derivation of our forecasting equation is consistent with the monetary model of exchange rates. Our model outperforms the random walk in out-of-sample forecasting of twelve major currency pairs in both short and long horizons forecasts for the 1990-2020 period. The results are robust for all sub-periods with the exception of years around the collapse of Lehman Brothers in September 2008. Our results are robust to alternative model specifications, single equation and panel estimation, recursive and rolling estimation, and alternate data construction methods. The model performs better when the long-maturity forward exchange rate is assumed to be stationary as opposed to assuming non-stationarity. The improvement in forecast accuracy of our model is economically and statistically significant for almost all exchange rate series. The model is simple, linear, easy to replicate, and the data we use are available in real time and not subject to revisions.

JEL Classification: F31; F37

Keywords: exchange rate; error correction; forecasting performance; monetary model; out-of-sample; random walk

For further information please refer to the attached annex, downloadable here.