Models for Forecasting Exchange Rates Essay Example | Topics and Well Written Essays - 2000 words

Models for Forecasting Exchange Rates - Essay Example 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