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Dynamic modelling for foreign exchange rates Kwok, Kelly Sin-Hung

Abstract

Since the advent of generalized floating exchange rates in 1973, the behavior of exchange rate movements has become an extremely challenging research area. Given the importance of a good understanding of foreign exchange rate dynamics in international asset pricing theories, international portfolio management and policy-oriented questions of an open economy, it is not surprising that exchange rate economics has been the subject of many investigations during the past two decades. Recent research indicates that standard linear macroeconomic models generally fail to improve upon the simple random walk model in out-of-sample forecasting. We present an empirical study (based on over 20 years of monthly data) of several models with dynamic state structure to forecast the foreign exchange rates of seven major currencies. As part of our study, we also employ various measures and visualization techniques to evaluate the performance of our candidate models in terms of expectation and risk forecastability. In addition to the commonly used statistical measures, we compare the models in seemingly practical situations. The performance measurement methodology for risk management is based on the concept of Value-at-Risk. The general conclusion of our study is that the performance of the forward rate model tends to be dominative. Our dynamic models are still not able to outperform the simple random walk for most of the studied exchange rates when performance is based upon the statistical measures; however, the simple random walk may not be unbeatable when performance is gauged from a practical point of view.

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