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Exchange rates and fundamentals: Forecasting with long maturity forward rates

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  • Darvas, Zsolt
  • Schepp, Zoltán

Abstract

We show that in a popular model of exchange rate determination, the unobserved expected future exchange rate can be substituted with the observed forward exchange rate. This allows the derivation of a new error-correction forecasting model, which approximates the gap between the fundamental equilibrium exchange rate and the actual exchange rate with the long-maturity forward exchange rate. Our out-of-sample forecasting results for major currencies are unprecedented. The forecasting model is simple, easy to replicate, and the data we use are available in real time and not subject to revisions.

Suggested Citation

  • Darvas, Zsolt & Schepp, Zoltán, 2024. "Exchange rates and fundamentals: Forecasting with long maturity forward rates," Journal of International Money and Finance, Elsevier, vol. 143(C).
    • Handle: RePEc:eee:jimfin:v:143:y:2024:i:c:s0261560624000548
    DOI: 10.1016/j.jimonfin.2024.103067
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    More about this item

    Keywords

    Exchange rates; Error correction; Forecasting performance; Monetary model; Out-of-sample; Random walk;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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