Exchange rate models with uncertain and incomplete information predict that investors focus on a small set of fundamentals that changes frequently over time. We design a model selection rule that captures the current set of fundamentals that best predicts the exchange rate. Out-of-sample tests show that the forecasts made by this rule significantly beat a random walk for 5 out of 10 currencies. Furthermore, the currency forecasts generate meaningful investment profits. We demonstrate that the strong performance of the model selection rule is driven by time-varying weights attached to a small set of fundamentals, in line with theory.

doi.org/10.1017/S0022109017000011, hdl.handle.net/1765/98872
ERIM Top-Core Articles
Journal of Financial and Quantitative Analysis
Erasmus School of Economics

Kouwenberg, R., Markiewicz, A., Verhoeks, R. (Ralph), & Zwinkels, R. (2017). Model Uncertainty and Exchange Rate Forecasting. Journal of Financial and Quantitative Analysis (Vol. 52, pp. 341–363). doi:10.1017/S0022109017000011