EXCHANGE RATE FUNDAMENTALS: EVIDENCE ON THE ECONOMIC VALUE OF PREDICTABILITY

Lucio Sarno (University of Warwick, UK)

A major puzzle in international finance is the inability of models based on monetary fundamentals to produce better out-of-sample forecasts than a naive random walk. While the relevant literature has generally evaluated exchange rate forecasts on the basis of conventional statistical measures of forecast accuracy, we ask a different but related question: Is there any economic value to exchange rate predictability provided by monetary fundamentals? We study, using a framework that allows for parameters uncertainty, the utility gains to a long-horizon investor who manages her optimal portfolio based on forecasts obtained using the information contained in monetary fundamentals. In sharp contrast to much previous research, we find that monetary fundamentals are powerful predictors of the exchange rate out of sample and that the economic value of the exchange rate forecasts implied by monetary fundamentals is substantially larger than the economic value of forecasts obtained using a random walk.