Structural, VAR and BVAR models of exchange rate determination: A comparison of their forecasting performance

This paper compares the out‐of‐sample forecasting accuracy of a wide class of structural, BVAR and VAR models for major sterling exchange rates over different forecast horizons. As representative structural models we employ a portfolio balance model and a modified uncovered interest parity model, with the latter producing the more accurate forecasts. Proper attention to the long‐run properties and the short‐run dynamics of structural models can improve on the forecasting performance of the random walk model. The structural model shows substantial improvement in medium‐term forecasting accuracy, whereas the BVAR model is the more accurate in the short term. BVAR and VAR models in levels strongly out predict these models formulated in difference form at all forecast horizons.