ERASMUS UNIVERSITY ROTTERDAM ERASMUS SCHOOL OF ECONOMICS MSc Economics & Business Master Specialization Financial Economics Exchange Rate Predictions: An Investigation of the Short-run Predictive Power of Fundamentals Author: L. Properzio Student number: 456449 Thesis supervisor: Mr. Sjoerd van den Hauwe Finish date: December 2017 PREFACE AND ACKNOWLEDGEMENTS I would like to express my gratitude to my supervisor Mr. Sjoerd van den Hauwe for its excellent guidance and support throughout the entire thesis drafting process. His prompt feedbacks and suggestions helped immensely in every step and improvement process of writing this thesis. Moreover, I would like to thank and express my profound gratitude to my parents and my boyfriend for having provided me continuous support and encouragement through my years of study. This accomplishment would not have been possible without them. I will be grateful forever for your love. NON-PLAGIARISM STATEMENT By submitting this thesis, the author declares to have written this thesis completely by himself/herself, and not to have used sources or resources other than the ones mentioned. All sources used, quotes and citations that were literally taken from publications, or that were in close accordance with the meaning of those publications, are indicated as such. COPYRIGHT STATEMENT The author has copyright of this thesis, but also acknowledges the intellectual copyright of contributions made by the thesis supervisor, which may include important research ideas and data. Author and thesis supervisor will have made clear agreements about issues such as confidentiality. Electronic versions of the thesis are in principle available for inclusion in any EUR thesis database and repository, such as the Master Thesis Repository of the Erasmus University Rotterdam ii Abstract Since the collapse of Bretton Wood system of fixed exchange rates, there have been many attempts to construct a model which can produce accurate and reliable forecasts of exchange rates. On the basis of these previous studies, the intent of this thesis is to construct three models capable to generate consistent and more accurate predictions than a driftless random walk model for the Euro/Dollar, Japanese Yen/Dollar, and Chinese Yuan/Dollar exchange rates. Considering past values of these exchange rates and price levels, determined by the CPI, I first built the Purchasing Power Parity model. However, since macroeconomic variables significantly influence exchange rates, I constructed a Monetary model and a Vector Autoregressive model in which are included macroeconomic fundamentals whose choice has been driven by the theoretical framework. All in all, the most important outcome of this research is that none of the models appeared to have a higher predictive power than the random walk model. Keywords: Exchange rates, Purchasing Power Parity, Monetary model, Vector Autoregressive model, In-Sample Predictions JEL Classification: F31, F37 iii TABLE OF CONTENTS PREFACE AND ACKNOWLEDGEMENTS.................................................................... ii Abstract ........................................................................................................................ iii TABLE OF CONTENTS ............................................................................................... iv LIST OF TABLES ......................................................................................................... vi LIST OF FIGURES ...................................................................................................... vii 1. Introduction ............................................................................................................. 1 Research question ................................................................................................... 2 2. Literature review ....................................................................................................... 3 2.1 Is there a relationship between exchange rates and macroeconomic variables? 3 2.2 The beginning of exchange rates forecasting theories ....................................... 5 2.3 Classification of exchange rate forecasting models ............................................ 7 2.4 The Purchasing Power Parity model .................................................................. 8 2.5 Macroeconomic models ..................................................................................... 9 2.6 Forecast combination techniques......................................................................12 2.7 Theoretical framework ......................................................................................12 2.7.1 Purchasing Power Parity ...........................................................................13 2.7.1.1 Absolute Purchasing Power Parity .....................................................13 2.7.1.2 Relative Purchasing Power Parity ......................................................14 2.7.1.3 Advantages and drawbacks of PPP model ........................................15 2.7.2 Monetary model ........................................................................................15 2.7.2.1 Flexible Prices Monetary Model .........................................................16 2.7.2.2 Sticky Prices Monetary Model ............................................................17 2.7.3 Vector Autoregressive (VAR) model ..........................................................17 2.7.4 Implications of the VAR model assumption of endogenous variables ........18 2.7.5 Combination of forecasts ...........................................................................19 3. Data and descriptive statistics .................................................................................20 3.1 Data transformation process .............................................................................21 3.2 Descriptive statistics .........................................................................................22 iv 4. Methodology and model construction ......................................................................25 4.1 Assumptions and specifications ........................................................................25 4.2 Purchasing Power Parity ...................................................................................25 4.3 Monetary model ................................................................................................26 4.4 Vector Autoregressive (VAR) model .................................................................28 4.4.1 Lag Length Selection .................................................................................29 4.4.2 Test for Granger causality .........................................................................30 4.5 Forecast Procedure ..........................................................................................30 4.6 Combination of forecasts ..................................................................................31 4.7 Validation tests .................................................................................................32 5. Empirical Results .....................................................................................................34 5.1 Regression Analysis .........................................................................................34 5.1.1 Purchasing Power Parity model: regressions analysis ...............................34 5.1.2 Monetary Model: regression analysis ........................................................35 5.1.3 Vector Autoregressive Model: regressions analysis ...................................37 5.1.4 Test for homoscedasticity and autocorrelation of residuals ............................40 5.2 Forecast comparison ........................................................................................45 5.3 Robustness test ................................................................................................47 Conclusion and Discussion .........................................................................................50 Limitations and suggestions for future researches ..................................................50 References ..................................................................................................................52 Appendix A: Definition of Monetary Market Equilibrium ...............................................56 Appendix B: System of matrix VAR model and regression results ...............................58 v LIST OF TABLES Table1: Interpolated Dickey-Fuller Test for unit roots ..................................................22 Table 2: Descriptive statistics for all variable ...............................................................24 Table 3: preliminary results for Euro/Dollar PPP calculation ........................................26 Table 4: Regressions estimations of the PPP model ...................................................35 Table 5: Regression output monetary model: EURUSD exchange rate .......................36 Table 6a: Lag length selection Euro/Dollar ..................................................................37 Table 6b: Lag length selection Japanese Yen/Dollar ...................................................38 Table 6c: Lag length selection Yuan/Dollar .................................................................38 Table 7a: Granger causality test results for Euro/Dollar exchange rate .......................39 Table 7b: Granger causality test results for Japanese