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Models for Forecasting Exchange Rates - Essay Example

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Models for Forecasting Exchange Rates

is a function of sample size = N M = N/log N

Schwartz criterion Consistent estimate of lag length

Akaike lag length Minimum mean square prediction errors
criterion of the dependent variable

Similar to AR Weight (W) is assigned arbitrarily W = 0.95

Random Walk model Current spot rate is a predictor of
the future spot rate;

Basic model Requires no estimation

With a drift parameter Mean monthly (logarithmic)
exchange rate change


These methods minimize criteria based on squared deviations; but it will be ineffective when the fluctuations in foreign exchange rates is unusual - and not as based on reasons established in various studies of fluctuations.


Multivariate Time Series Models - Unconstrained Vector Auto regression (VAR).(1. MEESE, Richard A.; ROGOFF; Kenneth)

Under VAR model, "contemporaneous value of each variable is regressed against lagged values of itself and all the other variables. The exchange rate equation is

st = a i i s - 1 + a l z s t - 2 +"" a i n s f - n + BilXt - 1+ 2 X t - 2 +"" B'iX,- + ui

where X,_j is a vector of the explanatory variables in the earlier equation, lagged jperiods." (1. MEESE, Richard A.; ROGOFF; Kenneth)

VAR yields better forecasts since it does not restrict any variables and is better equipped to tackle the estimation problems that plague the structural models.

Theoretical Models - Purchasing Power Parity Condition (PPP) , Sticky price monetary model of Dornbusch and Frankel , Balassa- Samuelson model based on productivity differentials, uncovered interest rate parity (UIP) (2. Cheung, Yin-Wong ; Chinn, Menzie D. ; Pascaul, Antonio Garcia)

Model Assumption / Determination


Purchasing Power Price indices...
Richard A. MEESE, Kenneth ROGOFF)
These methods minimize criteria based on squared deviations; but it will be ineffective when the fluctuations in foreign exchange rates is unusual - and not as based on reasons established in various studies of fluctuations.
Theoretical Models - Purchasing Power Parity Condition (PPP) , Sticky price monetary model of Dornbusch and Frankel , Balassa- Samuelson model based on productivity differentials, uncovered interest rate parity (UIP) (2. Cheung, Yin-Wong ; Chinn, Menzie D. ; Pascaul, Antonio Garcia)
"Let s be the log exchange rate, m and y be log domestic money stock and output and m* and y* be log foreign money stock and output. Following Mark, the money stock variables are constructed as four quarter moving averages, to eliminate seasonality. The fundamental value of the log exchange rate predicted by the monetary model is: f1 = (m-m*)-(y-y*)"
"This model states that the nominal exchange rate is determined by home-foreign differentials in the monetary fundamentals used above as well as short-term interest rates, expected inflation rates, and cumulated current account balances."
There is no evidence to suggest that exchange rate forecasts obtaine ...Show more

Summary

All the models mentioned above assume that the exchange rate has a value of "1" for a1 - the reason being that there is homogeneity in the money supplies. However, the uniformity ends there. The different assumptions and values assigned are as below:
The assumption that domestic and foreign variables will impact the above equation in differential form is based on a reasoning that there is an equality in the parameters of the domestic and foreign money demand and price adjustment…
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