Individual Exchange Rate Forecasts and Expected Fundamentals

Abstract

Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.Download this ZEW Discussion Paper from our ftp server:http://ftp.zew.de/pub/zew-docs/dp/dp11062.pdf Non-technical SummaryExchange rates are one of the most important prices in open economies. Despite their great importance for many enterprises, surprisingly little is known about the economic factors influencing the ups and downs of exchange rates at intermediate horizons. Although several theoretical macroeconomic models do identify potential determinants of exchange rates, empirical studies since the mid-1980s have found that these models do not make more accurate medium-term forecasts than random forecasts. This empirical finding has led to the conclusion that exchange rates and fundamentals are unrelated in the medium term. However, the complexity of currency markets (with heterogeneous market participants or time-variant influencing factors) could conceal a potential relation between economic fundamentals and exchange rates.The present study takes an indirect approach to investigating whether exchange rates are formed based on fundamentals. The defining idea behind our study is to analyze individual forecasts without making assumptions regarding the forecaster's macroeconomic models. Instead, we judge individual forecasts by their forecast ability only. We assume that good exchange rate forecasts are generally based on better information, and analyze whether this information is macroeconomic. To this end, we take a look at the forecast ability of individual forecasts for the USD/EUR exchange rate in conjunction with the forecast ability of associated short-term interest rate forecasts.We view the significant, positive relationship between good exchange rate forecasts (on a one-month horizon) and good interest rate forecast as evidence that exchange rate forecasts benefit from a better interpretation of the macroeconomic reality. This requires a fundamental linkage between exchange rates and macroeconomic variables.If this linkage exists, it should vary in its importance across different market phases. Our further analyses indeed indicate that a correlation between exchange rates and interest rates is especially important when there is an obvious fundamental misalignment between the respective countries. This is the case when there is a great difference between exchange rates and their fundamental values (based on purchasing power parity), when interest rate differences between the two currencies are large, and when exchange rates do not exhibit a strong tren...

Exchange rate expectations of chartists and fundamentalists

“…For both measures, we follow the concept introduced in Dick, MacDonald, and Menkhoff (2011) and translate the individual forecasts into trading strategies, going long USD (in the forward market) when they expect the USD to appreciate, and short when they expect the opposite. Each position will be closed in the spot market at the end of the investment period of k months.…”

Exchange Rate Expectations of Chartists and Fundamentalists

“…For both measures, we follow the concept introduced in Dick, MacDonald, and Menkhoff (2011) and translate the individual forecasts into trading strategies, going long USD (in the forward market) when they expect the USD to appreciate, and short when they expect the opposite. Each position will be closed in the spot market at the end of the investment period of k months.…”