Exchange Rate Forecasting

Exchange rate movement has been an important subject of macroeconomic analysis and market surveillance. Despite its importance, forecasting the exchange rate level has been a challenge for academics and market practitioners since the collapse of the Bretton Woods system. Empirical results from many of the exchange rate forecasting models in the literature have not yielded satisfactory results. This paper is constructed for the purpose of comparing the forecast performance of various competing models that have been suggested to forecast exchange rates. An overview and classifications of models are summarized in Section 2. Section 3 discusses the criteria used to evaluate forecasting performance. The forecasting results are reported in Section 4. Section 5 concludes and indicates why different studies provide different results on the issue.
2. An Overview and Classifications of Models
a. Purchasing Power Parity (PPP) Model
The PPP model explains the movements of the exchange rate between two economies’ currencies by the changes in the countries’ price levels. The goods-market arbitrage mechanism will move the exchange rate to equalise prices in the two economies (Madura 2006). Mathematically, the exchange rate determination under the PPP model is expressed as: lnet = lnpt – lnpt* where et is the nominal exchange rate, pt and pt* are domestic and foreign prices respectively.
The PPP model which is specified as a restrictive error-correction form, following that used in Cheung et al. (2004) is written as: lnet+h – lnet = αo + α1 (lnet - βo – β1lnp~t) + εt where p~t is the domestic price level relative to the foreign price level, εt is a zero mean error term, and h is the forecast horizon. The restrictive setup explicitly allows the variation of the exchange rate as a correction of its last-period deviation from a long-run equilibrium
b. Uncover Interest Rate Parity (UIP) Model
The UIP describes how the exchange rate moves according to the expected