FORECASTING PERFORMANCE OF EXCHANGE RATE MODELS: A COMPARISON OF ERROR SIZE AND DIRECTIONAL CORRECTNESS

This paper investigates the forecasting performance of three exchange rate models over the period 1973:Q4 - 1997:Q4. The 1973:Q4 - 1987:Q4 sub-period was used to estimate the models for the Canadian Dollar, British Pound, German Mark and Japanese Yen and the parameter estimates were then used to generate out-of-sample forecasts for the 1988:Q4 - 1997:Q4 period. Based on the differences between actual and predicted results and whether predicted results were directionally accurate the findings indicate that an econometric model based on economic fundamentals tended to outperform market-based spot and forward rate models. However, composite forecasts representing weighted averages of the three individual model forecasts outperformed even the econometric model particularly in the out-of-sample forecasts.