Forecasting the Euro exchange rate using vector error correction models

Abstract

Forecasting the Euro Exchange Rate Using Vector Error Correction Models. — This paper presents an exchange rate model for the Euro exchange rates of four major currencies, namely the US dollar, the British pound, the Japanese yen and the Swiss franc. The model is based on the monetary approach of exchange rate theory which uses fundamental macroeconomic variables to explain the exchange rate. A crucial point when using such a model is its proper estimation through cointegration analysis. The euro exchange rate model is therefore estimated in the form of a Vector Autoregressive (VAR) model with cointegrating vectors (VECM). We find that when cointegration analysis is undertaken properly, the naive random walk prediction can be out-performed for the US dollar, the British pound and the Japanese yen, but not for the Swiss franc.