A consumption-based approach to exchange rate predictability

Ojeda-Joya, Jair (2019): A consumption-based approach to exchange rate predictability.

Abstract

We study whether the implications of an international consumption-based asset-pricing model are useful to provide out-sample predictability evidence for the real exchange rate. This model implies a predictability equation that results from the presence of both internal and external consumption habits in the utility function. In this equation, domestic, U.S. and world consumption growth are predictors of the real exchange rate. Our empirical exercises confirm this connection by providing evidence of short-term predictability on the bilateral rates of 15 out of 17 countries vis-à-vis the U.S. over the post Bretton-Woods float. A non-linear GMM estimation of some parameters of the model also brings about evidence of the presence of consumption habits in the utility function.

• Item Type: MPRA Paper
• Language: English
• Keywords: exchange rates, out-of-sample, predictability, asset pricing, habits
• Subjects: C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F47 - Forecasting and Simulation: Models and Applications; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets

References

Abel, A. (1990). “Asset Prices under Habit Formation and Catching Up with the Joneses,” American Economic Review, 80(2): 38-42.

Abel, A. (2008). “Equity Premia with Benchmark Levels of Consumption: Closed-Form Results,” In: Mehra, R. (ed.) Handbook of the Equity Risk Premium: Elsevier, North-Holland, Amsterdam and Boston.

Backus, D., S. Foresi, and C. Telmer, (2001). “Affine Term-Structure Models and the Forward Premium Anomaly,” Journal of Finance, 56(1): 279-304.

Beckmann, J., and R. Czudaj, (2017). “The Impact of Uncertainty on Professional Exchange Rate Forecasts,” Journal of International Money and Finance, 73: 296-316.

Campbell, J. and J. Cochrane, (1999). “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior,” Journal of Political Economy, 107(2): 205–251.

Byrne, J., D. Korobilis, and P. Ribeiro, (2016). “Exchange Rate Predictability in a Changing World,” Journal of International Money and Finance, 62: 1-24.

Cerra, V., and S. C. Saxena, (2010). “The Monetary Model Strikes Back: Evidence from the World,” Journal of International Economics, 81(2), 2010, 184-196.

Clark, T. and K. West, (2006). “Using Out-of-Sample Mean Square Prediction Errors to Test the Martingale Difference Hypothesis,” Journal of Econometrics, 135: 155-186.

Clark, T. and K. West, (2007). “Approximately Normal Tests for Equal Predictive Accuracy in Nested Models,” Journal of Econometrics, 138(1): 291-311.

Cliff, M, (2003). “GMM and MINZ Program Libraries for MATLAB,” Manuscript. Purdue University, Krannert Graduate School of Management.

Cochrane, J, (2005). “Asset Pricing,” Princeton University Press, Princeton NJ, Revised Edition.

Colacito, R. and M. Croce, (2011). “Risks for the Long Run and the Real Exchange Rate,” Journal of Political Economy, 119(1): 153-181.

Engel, C., N. Mark and K. West, (2007). “Exchange Rate Models Are Not as Bad as You Think,” NBER Macroeconomics Annual 2007. Edited by D. Acemoglu, K. Rogoff, and M. Woodford. National Bureau of Economic Research, Cambridge, MA.

Engel, C., and K. West, (2005). “Exchange Rates and Fundamentals,” The Journal of Political Economy, 113(3): 485-517.

Fama, E, (1984). “Forward and Spot Exchange Rates,” Journal of Monetary Economics, 14: 319–338.

Foroni, C., F. Ravazzolo, and B. Sadaba, (2018). “Assessing the Predictive Ability of Sovereign Default Risk on Exchange Rate Returns,” Journal of International Money and Finance, 81: 242-264.

Fratzscher, M., D. Rime, L. Sarno, and G. Zinna, (2015). “The Scapegoat Theory of Exchange Rates: The First Tests,” Journal of Monetary Economics, 70: 1-21.

Gourinchas, P. and H. Rey, (2007). “International Financial Adjustment,” Journal of Political Economy, 115(4): 665-703.

Gourio, F., M. Siemer, and A. Verdelhan, (2013). “International Risk Cycles,” Journal of International Economics, 89: 471-484.

Groen, J., (2005). “Exchange Rate Predictability and Monetary Fundamentals in a Small Country Panel,” Journal of Money, Credit and Banking, 37(3): 495-516.

Hansen, L., (1982). “Large Sample Properties of Generalized Method of Moments Estimators,” Econometrica, 50: 1029-1054.

Ince, O., T. Molodtsova, and D. Papell, (2016). “Taylor Rule Deviations and Out-of-Sample Exchange Rate Predictability,” Journal of International Money and Finance, 69: 22-44.

Lustig, H., and A. Verdelhan, (2007). “The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk,” American Economic Review, 97(1): 89-117.

Mark, N., (1995). “Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability,” The American Economic Review, 85(1): 201-218.

Mark, N. and D. Sul, (2001). “Nominal Exchange Rates and Monetary Fundamentals: Evidence from a Small Post Bretton-Woods Panel,” Journal of International Economics, 53: 29-52.

Meese, R. and K. Rogoff, (1983). “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics, 14: 3-24.

Molodtsova, T. and D. Papell, (2009). “Out-of-Sample Exchange Rate Predictability with Taylor Rule fundamentals,” Journal of International Economics, 77: 167-180.

Ojeda-Joya, J. (2014). “A Consumption-Based Approach to Exchange Rate Predictability,” Borradores de Economia #857, Banco de la Republica, Colombia.

Rogoff, K., (1996). “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, 34(2): 647-668.

Rogoff, K. and V. Stavrakeva, (2008). “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting,” NBER Working Papers #14701, National Bureau of Economic Research, Cambridge, MA.

Rossi, B. (2013). “Exchange Rate Predictability,” Journal of Economic Literature, 51(4): 1063–1119.

Sarno, L. and G. Valente, (2009). “Exchange Rates and Fundamentals: Footloose or Evolving Relationship?” Journal of the European Economic Association, 7(4): 786-830.

Taylor, A. and M. Taylor, (2004). “The Purchasing Power Parity Debate,” Journal of Economic Perspectives, 18(4): 135-158.

Verdelhan, A. (2010). “A Habit-Based Explanation of the Exchange-Rate -risk Premium,” The Journal of Finance, 65(1): 123-146.