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Predictability and forecasting performance of major euro exchange rates using a relative PPP-based equilibrium model

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  • Grossmann, Axel
  • Simpson, Marc W.

Abstract

Using an alternative approach to the real exchange rate, we investigate the predictability of major currencies against the euro and its predecessors, the EUA and ECU. The unique forecasting methodology is based on deviations from a relative PPP-equilibrium exchange rate (EER), which is constructed from the EERs of individual euro member countries going back to 1974. Testing the mean reverting behavior, we report half-lives of less than two years and some less than one year. Predicting exchange rate movements, we find average success rates of the euro converging toward the constructed EERs of higher than 70%, especially over 12-month horizons and when deviations are large. Employing a linear recursive forecasting methodology, the model statistically significantly outperforms the random walk model at horizons of close to or less than one year and in some cases over a 1-month forecasting horizon. Finally, the forecasting performance increases during crisis periods.

Suggested Citation

  • Grossmann, Axel & Simpson, Marc W., 2023. "Predictability and forecasting performance of major euro exchange rates using a relative PPP-based equilibrium model," Research in International Business and Finance, Elsevier, vol. 66(C).
    • Handle: RePEc:eee:riibaf:v:66:y:2023:i:c:s0275531923001617
    DOI: 10.1016/j.ribaf.2023.102035
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    References listed on IDEAS

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    1. Simpson, Marc W., 2004. "Selectively hedging the US dollar with foreign exchange futures contracts," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 14(1), pages 75-86, February.
    2. McMillan, David G., 2009. "The confusing time-series behaviour of real exchange rates: Are asymmetries important?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(4), pages 692-711, October.
    3. Ren, Yu & Liang, Xuanxuan & Wang, Qin, 2021. "Short-term exchange rate forecasting: A panel combination approach," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 73(C).
    4. Ponomareva, Natalia & Sheen, Jeffrey & Wang, Ben Zhe, 2019. "Forecasting exchange rates using principal components," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 63(C).
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Relative purchasing power parity; Exchange rate equilibrium; Half-lives; Euro; Forecasting;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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