Short-run forecasting of the euro-dollar exchange rate with economic fundamentals

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1 13SHORT-RUN FORECASTING OF THE EURO-DOLLAR EXCHANGE RATE WITH ECONOMIC FUNDAMENTALS 2012 Marcos dal Bianco, Maximo Camacho and Gabriel Perez-Quiros Documentos de Trabajo N

2 13SHORT-RUN FORECASTING OF THE EURO-DOLLAR EXCHANGE RATE WITH ECONOMIC FUNDAMENTALS

3 13SHORT-RUN FORECASTING OF THE EURO-DOLLAR EXCHANGE RATE WITH ECONOMIC FUNDAMENTALS (*) Marcos dal Bianco BBVA RESEARCH Maximo Camacho UNIVERSIDAD DE MURCIA Gabriel Perez-Quiros BANCO DE ESPA05A (*) Camacho acknowledges financial support from MICINN (ECO ). The authors are grateful to the editor, the anonymous referees, participants to the Econometrics Workshop at the University of Alicante, XXXII Symposium on Economic Analysis, and the XLV Meeting of the Argentinean Association of Political Economy for their very useful comments. Any remaining errors are our own responsibility. The views in this paper are those of the authors and do not represent the views of the Bank of Spain. Documentos de Trabajo. N

The authors are grateful to the editor, the anonymous referees, participants to the Econometrics Workshop at the University of Alicante, XXXII Symposium on Economic Analysis, and the

4 13The Working Paper Series seeks to disseminate original research in economics and fi nance. All papers have been anonymously refereed. By publishing these papers, the Banco de Espa09a aims to contribute to economic analysis and, in particular, to knowledge of the Spanish economy and its international environment. The opinions and analyses in the Working Paper Series are the responsibility of the authors and, therefore, do not necessarily coincide with those of the Banco de Espa09a or the Eurosystem. The Banco de Espa09a disseminates its main reports and most of its publications via the INTERNET at the following website: Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. 08 BANCO DE ESPA05A, Madrid, 2012 ISSN: (on line)

The opinions and analyses in the Working Paper Series are the responsibility of the authors and, therefore, do not necessarily coincide with those of the Banco de Espa09a or the Eurosystem.

5 13Abstract We propose a fundamentals-based econometric model for the weekly changes in the euro-dollar rate with the distinctive feature of mixing economic variables quoted at different frequencies. The model obtains good in-sample fi t and, more importantly, encouraging outof-sample forecasting results at horizons ranging from one week to one month. Specifi cally, we obtain statistically signifi cant improvements upon the hard-to-beat random walk model using traditional statistical measures of forecasting error at all horizons. Moreover, our model improves greatly when we use the direction-of-change metric, which has more economic relevance than other loss measures. With this measure, our model performs much better at all forecasting horizons than a naive model that predicts the exchange rate has an equal chance to go up or down, with statistically signifi cant improvements. Keywords: euro-dollar rate, exchange rate forecasting, State-space model, mixed frequencies. JEL classification: F31, F37, C01, C22.

Specifi cally, we obtain statistically signifi cant improvements upon the hard-to-beat random walk model using traditional statistical measures of forecasting error at all horizons.

6 13Resumen Se propone un modelo economtrico basado en fundamentales para el cambio semanal del tipo de cambio del euro frente al dlar con la caracterstica diferencial de mezclar variables con diferentes frecuencias. El modelo obtiene buenas predicciones en la muestra, y, lo que es ms importante, mejoras en prediccin fuera de la muestra a horizontes entre una semana y un mes. Especfi camente, obtenemos mejoras estadsticamente signifi cativas frente al difcil de batir paseo aleatorio, usando las medidas tradicionales basadas en error de prediccin cuadrtico medio a todos los horizontes. Las ganancias son mayores cuando utilizamos la mtrica basada en la direccin del cambio, que tiene ms sentido econmico en un modelo como este. Con esta medida, nuestro modelo predice los movimientos alcistas y bajistas del tipo de cambio mucho mejor que un modelo basado en igual probabilidad de bajadas y subidas. Palabras claves: Tipo de cambio euro-dlar, prediccin de tipos de cambio, modelo de ecuacin de estados y frecuencias mixtas. Cdigos JEL: F31, F37, C01, C22.

Especfi camente, obtenemos mejoras estadsticamente signifi cativas frente al difcil de batir paseo aleatorio, usando las medidas tradicionales basadas en error de prediccin cuadrtico medio a todos

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39 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Source: Datastream Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Source: Datastream Feb-99 Jun-99 Oct-99 Feb-00 Jun-00 Oct-00 Feb-01 Jun-01 Oct-01 Feb-02 Jun-02 Oct-02 Feb-03 Jun-03 Oct-03 Feb-04 Jun-04 Oct-04 Feb-05 Jun-05 Oct-05 Feb-06 Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Source: Datastream BANCO DE ESPA05A 39 DOCUMENTO DE TRABAJO N

40 13BANCO DE ESPA05A PUBLICATIONS WORKING PAPERS GABE J. DE BONDT, TUOMAS A. PELTONEN AND DANIEL SANTAB09RBARA: Booms and busts in China's stock market: Estimates based on fundamentals. CARMEN MART01NEZ-CARRASCAL AND JULIAN VON LANDESBERGER: Explaining the demand for money by nonfinancial corporations in the euro area: A macro and a micro view. CARMEN MART01NEZ-CARRASCAL: Cash holdings, firm size and access to external finance. Evidence for the euro area. C07SAR ALONSO-BORREGO: Firm behavior, market deregulation and productivity in Spain. OLYMPIA BOVER: Housing purchases and the dynamics of housing wealth. DAVID DE ANTONIO LIEDO AND ELENA FERN09NDEZ MU05OZ: Nowcasting Spanish GDP growth in real time: One and a half months earlier. FRANCESCA VIANI: International financial flows, real exchange rates and cross-border insurance. FERNANDO BRONER, TATIANA DIDIER, AITOR ERCE AND SERGIO L. SCHMUKLER: Gross capital flows: dynamics and crises. GIACOMO MASIER AND ERNESTO VILLANUEVA: Consumption and initial mortgage conditions: evidence from survey data. PABLO HERN09NDEZ DE COS AND ENRIQUE MORAL-BENITO: Endogenous fiscal consolidations. C07SAR CALDER07N, ENRIQUE MORAL-BENITO AND LUIS SERV07N: Is infrastructure capital productive? A dynamic heterogeneous approach. MICHAEL DANQUAH, ENRIQUE MORAL-BENITO AND BAZOUMANA OUATTARA: TFP growth and its determinants: nonparametrics and model averaging. JUAN CARLOS BERGANZA AND CARMEN BROTO: Flexible inflation targets, forex interventions and exchange rate volatility in emerging countries. FRANCISCO DE CASTRO, JAVIER J. P07REZ AND MARTA RODR01GUEZ VIVES: Fiscal data revisions in Europe. ANGEL GAVIL09N, PABLO HERN09NDEZ DE COS, JUAN F. JIMENO AND JUAN A. ROJAS: Fiscal policy, structural reforms and external imbalances: a quantitative evaluation for Spain. EVA ORTEGA, MARGARITA RUBIO AND CARLOS THOMAS: House purchase versus rental in Spain. ENRIQUE MORAL-BENITO: Dynamic panels with predetermined regressors: likelihood-based estimation and Bayesian averaging with an application to cross-country growth. NIKOLAI ST02HLER AND CARLOS THOMAS: FiMod C a DSGE model for fiscal policy simulations. 09LVARO CARTEA AND JOS07 PENALVA: Where is the value in high frequency trading? FILIPA S09 AND FRANCESCA VIANI: Shifts in portfolio preferences of international investors: an application to sovereign wealth funds. REBECA ANGUREN MART01N: Credit cycles: Evidence based on a non-linear model for developed countries. LAURA HOSPIDO: Estimating non-linear models with multiple fixed effects: A computational note. ENRIQUE MORAL-BENITO AND CRISTIAN BARTOLUCCI: Income and democracy: Revisiting the evidence. AGUST01N MARAVALL HERRERO AND DOMINGO P07REZ CA05ETE: Applying and interpreting model-based seasonal adjustment. The euro-area industrial production series. JULIO C09CERES-DELPIANO: Is there a cost associated with an increase in family size beyond child investment? Evidence from developing countries. DANIEL P07REZ, VICENTE SALAS-FUM09S AND JES03S SAURINA: Do dynamic provisions reduce income smoothing using loan loss provisions? GALO NU05O, PEDRO TEDDE AND ALESSIO MORO: Money dynamics with multiple banks of issue: evidence from Spain RAQUEL CARRASCO, JUAN F. JIMENO AND A. CAROLINA ORTEGA: Accounting for changes in the Spanish wage distribution: the role of employment composition effects. 1. Previously published Working Papers are listed in the Banco de Espa09a publications catalogue.

41 FRANCISCO DE CASTRO AND LAURA FERN09NDEZ-CABALLERO: The effects of fiscal shocks on the exchange rate in Spain JAMES COSTAIN AND ANTON NAKOV: Precautionary price stickiness ENRIQUE MORAL-BENITO: Model averaging in economics GABRIEL JIM07NEZ, ATIF MIAN, JOS07-LUIS PEYDR07 AND JES03S SAURINA: Local versus aggregate lending channels: the effects of securitization on corporate credit supply ANTON NAKOV AND GALO NU05O: A general equilibrium model of the oil market DANIEL C. HARDY AND MAR01A J. NIETO: Cross-border coordination of prudential supervision and deposit guarantees LAURA FERN09NDEZ-CABALLERO, DIEGO J. PEDREGAL AND JAVIER J. P07REZ: Monitoring sub-central government spending in Spain CARLOS P07REZ MONTES: Optimal capital structure and regulatory control JAVIER ANDR07S, JOS07 E. BOSC09 AND JAVIER FERRI: Household debt and labour market fluctuations ANTON NAKOV AND CARLOS THOMAS: Optimal monetary policy with state-dependent pricing JUAN F. JIMENO AND CARLOS THOMAS: Collective bargaining, firm heterogeneity and unemployment ANTON NAKOV AND GALO NU05O: Learning from experience in the stock market ALESSIO MORO AND GALO NU05O: Does TFP drive housing prices? A growth accounting exercise for four countries CARLOS PEREZ MONTES: Regulatory bias in the price structure of local telephone services. MAXIMO CAMACHO, GABRIEL PEREZ-QUIROS AND PILAR PONCELA: Extracting non-linear signals from several economic indicators. MARCOS DAL BIANCO, MAXIMO CAMACHO AND GABRIEL PEREZ-QUIROS: Short-run forecasting of the euro-dollar exchange rate with economic fundamentals. Unidad de Publicaciones Alcal 522, Madrid Telephone Fax publicaciones@bde.es

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