Atlantic Economic Journal

, Volume 43, Issue 1, pp 147–159 | Cite as

Exchange Rates and Fundamentals: A New Look at the Evidence on Long-Horizon Predictability

Article

Abstract

A widely held view in finance is that there is predictability in stock returns, bond returns, and exchange rates and that this predictability increases with the forecast horizon. Conventional tests for long horizon predictability may reject the null too frequently when the predictor variable is highly persistent and endogenous and there are overlapping observations creating unintended autocorrelation errors. We use a recently developed econometric technique to investigate predictability in short versus long horizon exchange rates. This procedure negates the historical bane of overlapping data i.e., the autocorrelation problem. This metric has strong and stable asymptotic properties even in small samples. We conduct extensive examination across a broad spectrum of time horizons, and find that the evidence for predictability is not as strong as previously stated.

Keywords

Exchange rate prediction Overlapping observations Correlation persistence Bonferroni inequality 

JEL

F3 

References

  1. Asness, C. (2003). Fight the fed model: the relationship between future returns and stock and bond market yields. Journal of Portfolio Management, 30(1), 11–24.CrossRefGoogle Scholar
  2. Berkowitz, J., and Giorgianni, L. (2001). Long-horizon exchange rate predictability? Review of Economics and Statistics, 83(1), 81–91.CrossRefGoogle Scholar
  3. Campbell, J. Y. (2000). Asset pricing at the millennium. Journal of Finance, 55(4), 1515–1567.CrossRefGoogle Scholar
  4. Campbell, J. Y., and Shiller, R. J. (1988). Stock prices, earnings, and expected dividends. Journal of Finance, 43(3), 661–676.CrossRefGoogle Scholar
  5. Campbell, J. Y., and Yogo, M. (2006). Efficient tests of stock return predictability. Journal of Financial Economics, 81(1), 27–60.CrossRefGoogle Scholar
  6. Campbell, J. Y., Lo, A. W., and Craig MacKinlay, A. (1997). The econometrics of financial markets. Princeton: Princeton University Press.Google Scholar
  7. Chen, W. W., and Deo, R. S. (2009). Bias Reduction and Likelihood-Based Almost Exactly Sized Hypothesis Testing in Predictive Regressions Using the Restricted Likelihood. Econometric Theory, 25(5), 1143–1179.CrossRefGoogle Scholar
  8. Chen, J., and Mark, N. C. (1996). Alternative long-horizon exchange-rate predictors. International Journal of Finance and Economics, 1(4), 229–250.CrossRefGoogle Scholar
  9. Chinn, M. D., and Meese, R. A. (1995). Banking on currency forecasts: how predictable is change in money? Journal of International Economics, 38(1–2), 161–178.CrossRefGoogle Scholar
  10. Clark, T. E., and McCracken, M. W. (2001). Tests of equal forecast accuracy and encompassing for nested models. Journal of Econometrics, 105(1), 85–110.CrossRefGoogle Scholar
  11. Clark, T. E., and McCracken, M. W. (2005). The power of tests of predictive ability in the presence of structural breaks. Journal of Econometrics, 124(1), 1–31.CrossRefGoogle Scholar
  12. Cochrane, J. H. (1999). New facts in finance. Federal Reserve Bank of Chicago Economic Perspectives, 23(3), 36–58.Google Scholar
  13. Cremers, K. J., and Martijn. (2002). Stock return predictability: a bayesian model selection perspective. Review of Financial Studies, 15(4), 1223–1249.CrossRefGoogle Scholar
  14. Fama, E. F., and French, K. R. (1988). Dividend yields and expected stock returns. Journal of Financial Economics, 22(1), 3–25.CrossRefGoogle Scholar
  15. Faust, J., Rogers, J. H., and Wright, J. H. (2003). Exchange rate forecasting: the errors we’ve really made. Journal of International Economics, 60(1), 35–59.CrossRefGoogle Scholar
  16. Foster, F. D., Smith, T., and Whaley, R. E. (1997). Assessing goodness-of-fit of asset pricing models: the distribution of the maximal r-squared. Journal of Finance, 52(2), 591–607.Google Scholar
  17. Hansen, L. P., and Hodrick, R. J. (1980). Forward exchange rates as optimal predictors of future spot rates: an econometric analysis. Journal of Political Economy, 88(5), 829–853.CrossRefGoogle Scholar
  18. Hjalmarsson, E. (2011). New methods for inference in long-horizon regressions. Journal of Financial and Quantitative Analysis, 46(3), 815–839.CrossRefGoogle Scholar
  19. Hodrick, R. J. (1992). Dividend yields and expected stock returns: alternative procedures for inference and measurement. Review of Financial Studies, 5(3), 357–386.CrossRefGoogle Scholar
  20. Kilian, L., and Taylor, M. P. (2003). Why is it so difficult to beat the random walk forecast of exchange rates? Journal of International Economics, 60(1), 85–107.CrossRefGoogle Scholar
  21. Lettau, M., and Ludvigson, S. C. (2005). Expected returns and expected dividend growth. Journal of Financial Economics, 76(3), 583–626.CrossRefGoogle Scholar
  22. Lewellen, J. (2004). Predicting returns with financial ratios. Journal of Financial Economics, 74(2), 209–235.CrossRefGoogle Scholar
  23. MacDonald, R., and Marsh, I. W. (1997). On fundamentals and exchange rates: a casselian perspective. Review of Economics and Statistics, 79(4), 655–664.CrossRefGoogle Scholar
  24. Mankiw, N. G., and Shapiro, M. D. (1986). Do we reject too often? Economics Letters, 20(2), 139–145.CrossRefGoogle Scholar
  25. Mark, N. C. (1995). Exchange rates and fundamentals: evidence on long-horizon predictability. American Economic Review, 85(1), 201–218.Google Scholar
  26. McCracken, M. W., and Stephen G. S. (2005). “Evaluating the predictability of exchange rates using long-horizon regressions: Mind your p's and q's!.” Journal Of Money, Credit, And Banking, 37(3), 473--494.Google Scholar
  27. Meese, R. A., and Rogoff, K. (1983a). Empirical exchange rate models of the seventies: do they fit out of sample? Journal of International Economics, 14(1–2), 3–24.CrossRefGoogle Scholar
  28. Meese, R. A., and Rogoff, K. (1983b). The out-of-sample failure of empirical exchange rate models: Sampling error or misspecification? In J. Frenkel (Ed.), Exchange rates and international macroeconomics. Chicago: University of Chicago Press.Google Scholar
  29. Meese, R. A., and Rogoff, K. (1988). Was it real? The exchange rate-interest differential relation over the modern floating-rate period. Journal of Finance, 43(4), 933–948.CrossRefGoogle Scholar
  30. Menzly, L., Santos, T., and Veronesi, P. (2004). Understanding predictability. Journal of Political Economy, 112(1), 1–47.CrossRefGoogle Scholar
  31. Nelson, C. R., and Kim, M. J. (1993). Predictable stock returns: the role of small sample bias. Journal of Finance, 48(2), 641–661.CrossRefGoogle Scholar
  32. Newey, W. K., and West, K. D. (1987). A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica, 55(3), 703–708.CrossRefGoogle Scholar
  33. Phillips, P. C. B. (1991). “Optimal inference in cointegrated systems.” Econometrica, 59(2) 283--306.Google Scholar
  34. Poterba, J. M., and Summers, L. H. (1988). Mean reversion in stock prices. Journal of Financial Economics, 22(1), 27–59.CrossRefGoogle Scholar
  35. Rapach, D. E., and Wohar, M. E. (2002). Testing the monetary model of exchange rate determination: new evidence from a century of data. Journal of International Economics, 58(2), 359–385.CrossRefGoogle Scholar
  36. Richardson, M., and Smith, T. (1991). Tests of financial models in the presence of overlapping observations. Review of Financial Studies, 4(2), 227–254.CrossRefGoogle Scholar
  37. Richardson, M. P., and Smith, T. (1994). A unified approach to testing for serial correlation in stock returns. Journal of Business, 67(3), 371–399.CrossRefGoogle Scholar
  38. Richardson, M., and Stock, J. H. (1989). Drawing inferences from statistics based on multiyear asset returns. Journal of Financial Economics, 25(2), 323–348.CrossRefGoogle Scholar
  39. Stambaugh, R. F. (1999). Predictive regressions. Journal of Financial Economics, 54(3), 375–421.CrossRefGoogle Scholar
  40. Taylor, M. P., Peel, D. A., and Sarno, L. (2001). Nonlinear mean-reversion in real exchange rates: toward a solution to the purchasing power parity puzzles. International Economic Review, 42(4), 1015–1042.CrossRefGoogle Scholar
  41. Valkanov, R. (2003). Long-horizon regressions: theoretical results and applications. Journal of Financial Economics, 68(2), 201–232.CrossRefGoogle Scholar
  42. Welch, I., and Goyal, A. (2008). A comprehensive look at the empirical performance of equity premium prediction. Review of Financial Studies, 21(4), 1455–1508.CrossRefGoogle Scholar
  43. Yin-Wong, C., Chinn, M. D., and Pascual, A. G. (2005). Empirical exchange rate models of the nineties: are any fit to survive? Journal of International Money And Finance, 24(7), 1150–1175.CrossRefGoogle Scholar

Copyright information

© International Atlantic Economic Society 2014

Authors and Affiliations

  1. 1.Richards College of BusinessUniversity of West GeorgiaCarrolltonUSA

Personalised recommendations