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IDENTIFYING EXCHANGE RATE COMMON FACTORS
Author(s) -
GreenawayMcGrevy Ryan,
Mark Nelson C.,
Sul Donggyu,
Wu JyhLin
Publication year - 2018
Publication title -
international economic review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.658
H-Index - 86
eISSN - 1468-2354
pISSN - 0020-6598
DOI - 10.1111/iere.12334
Subject(s) - purchasing power parity , exchange rate , econometrics , economics , model selection , random walk , factor analysis , identification (biology) , liberian dollar , statistics , mathematics , monetary economics , finance , botany , biology
Using recently developed model selection procedures, we determine that exchange rate returns are driven by a two‐factor model. We identify them as a dollar factor and a euro factor. Exchange rates are thus driven by global, U.S., and euro‐zone stochastic discount factors. The identified factors can also be given a risk‐based interpretation. Identification motivates multilateral models for bilateral exchange rates. Out‐of‐sample forecast accuracy of empirically identified multilateral models dominates the random walk and a bilateral purchasing power parity fundamentals prediction model. Twenty‐four‐month‐ahead forecast accuracy of the multilateral model dominates those of a principal components forecasting model.