CAN ECONOMISTS FORECAST EXCHANGE RATES? IF SO, IS IT PROFITABLE?

Barry A GOSS (Monash University)
S. Gülay AVŞAR (Victoria University of Technology)

Critics claim that traditional economic models explain a near zero proportion of exchange rate variation, and cannot outperform a random walk in post-sample forecasting. Perceived deficiencies include undue reliance on single equation methods and inadequate modelling of expectations. In addressing these issues, this paper develops a simultaneous rational expectations model of the US dollar/Deutschemark market, using information from both spot and futures markets.

Post-sample, this model significantly outperforms forecasts by rival predictors such as a random walk and a lagged futures rate. This latter comparison suggests that the market is not semi-strong form efficient. A trading routine based on the model produced significant returns after allowance is made for the Treasury Bill rate and the variability of returns.