Factor Model Forecasts of Exchange Rates Revisited

Abstract

This paper constructs factor-based fundamental exchange rates with independent component factors and then re-examines the superiority of factor models in out-predicting nominal exchange rates. By applying the panel data of 17 OECD countries over the period 1973-2011, this article finds that both the factor model and its PPP and TR fundamentals augmented models reveal strong evidence of defeating the random walk benchmark for medium and long horizons regardless of sample periods.