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Identifying exchange rate common factors. (English) Zbl 1419.91505

Summary: 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.

MSC:

91B64 Macroeconomic theory (monetary models, models of taxation)
62P20 Applications of statistics to economics
62M20 Inference from stochastic processes and prediction
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