Predictability and forecasting performance of major euro exchange rates using a relative PPP-based equilibrium model

Abstract

Using an alternative approach to the real exchange rate, we investigate the predictability of major currencies against the euro and its predecessors, the EUA and ECU. The unique forecasting methodology is based on deviations from a relative PPP-equilibrium exchange rate (EER), which is constructed from the EERs of individual euro member countries going back to 1974. Testing the mean reverting behavior, we report half-lives of less than two years and some less than one year. Predicting exchange rate movements, we find average success rates of the euro converging toward the constructed EERs of higher than 70%, especially over 12-month horizons and when deviations are large. Employing a linear recursive forecasting methodology, the model statistically significantly outperforms the random walk model at horizons of close to or less than one year and in some cases over a 1-month forecasting horizon. Finally, the forecasting performance increases during crisis periods.