Stability of predictors and the forecasting of foreign exchange rates

Abstract

The forecasting of foreign exchange rates is like reading tea leaves to some and a sophisticated form of economic analysis to others. Several firms currently earn substantial profits selling exchange-rate forecasts based on various models and with different track records. This study critically reviews the pitfalls and the merits of existing approaches to forecasting foreign exchange rates and introduces a new element in the forecasting model: the stability of predictors. The findings are that stability variables do improve the forecasting ability of an econometrically based model. The results of the suggested model are superior to those derived using the forward rate and the current spot rate as forecasting tools for future spot rates. The forecasting model developed here is shown to be transferable from one currency to another. The utilization of complex statistical techniques in the forecasting of foreign exchange rates depends on whether or not the foreign exchange markets are efficient. The foreign exchange market that is efficient in any sense (weak, semistrong, and strong) is signaling foreign exchange managers that regardless of the forecasting technique employed-sophisticated econometric models, simple forecasting tools, or chart reading-the market cannot be beaten. A simple, costless forecasting tool continuously observable in the marketplace, such as the forward rate, should prove to be a sufficient predictor of the future spot rate if markets are functioning efficiently. Empirical tests on the efficiency of the foreign exchange markets suffer the following drawbacks: 1.