Model Uncertainty and Exchange Rate Forecasting

R. Kouwenberg, A. Markiewicz, R. Verhoeks, R.C.J. Zwinkels

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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.
Original languageEnglish
Pages (from-to)341-363
Number of pages23
JournalJournal of Financial and Quantitative Analysis
Issue number1
Early online date20 Feb 2017
Publication statusPublished - Feb 2017

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