Do stock markets have predictive content for exchange rate movements?

• Published date: 01 November 2019
• DOI: http://doi.org/10.1002/for.2592
• Date: 01 November 2019
• Author: Shiu‐Sheng Chen,Cheng‐Che Hsu

Received: 11 November 2018 Accepted: 12 March 2019

DOI: 10.1002/for.2592

RESEARCH ARTICLE

Do stock markets have predictive content for exchange

rate movements?

Shiu-Sheng Chen Cheng-Che Hsu

Department of Economics, National

Taiwan University,Taipei, Taiwan

Correspondence

Shiu-Sheng Chen, Department of

Economics, National Taiwan University,

Social Science Building No. 1, Sec. 4,

Roosevelt Road, Taipei,Taiwan.

Email: sschen@ntu.edu.tw

Abstract

This paper examines short-horizon exchange rate predictability and investigates

whether stock returns contain information for forecasting daily exchange rate

movements. Inspired by the uncovered equity parity condition, we show that

stock return differentials have in-sample and out-of-sample predictive power for

nominal exchange rates with short horizons (1-day-ahead predictions). That is,

stock markets inform us about exchange rate movements, at least in the case of

high-frequency data.

KEYWORDS

exchange rates, forecasting, uncovered equity parity

1INTRODUCTION

Following the seminal paper by Meese and Rogoff (1983),

beating the random walk model in forecasting nomi-

nal exchange rates out-of-sample has posed a challenge

in the field of international economics. In their highly

cited work, Meese and Rogoff show that exchange rate

forecasting with macroeconomic fundamentals at short

horizons has been frustratingly disappointing. Follow-up

studies, including Cheung, Chinn, and Pascual (2005),

show that no single exchange rate model can consistently

out-forecast a random walk model in out-of-sample pre-

dictions, considering a variety of forecasting horizons.

Recently, more positive short-term forecasting results

have been reported by a growing number of studies.

For example, Gourinchas and Rey (2007) show that the

exchange rate is forecastable in- and out-of-sample at

one quarter and beyond using net foreign assets mod-

els. Molodtsova and Papell (2009) provide strong evi-

dence of short-horizon exchange rate predictability with

Taylor-rule fundamentals based on the out-of-sample test

statistic developed by Clark and West (2007). Li, Tsiakas,

and Wang (2015) find that economic fundamentals have

predictive power for exchange rates when prediction is

based on a kitchen-sink regression that incorporates a

large number of economic fundamentals. See Rossi (2013)

for a thorough review of the recent literature. Accordingto

Rossi:

[a]lthough there is disagreement in the lit-

erature, overall the empirical evidence is

not favorable to traditional economic pre-

dictors (such as interest rates, prices, out-

put, and money). Instead, Taylor-rule funda-

mentals and net foreign asset positions have

promising out-of-sample forecasting ability

for exchange rates. The consensus in the lit-

erature is that the latter fundamentals have

more out-of-sample predictive content than

traditional fundamentals. (Rossi, 2013, p.

1066)

However, Rogoff and Stavrakeva (2008) have shown

that the successful forecasting of short-term exchange

rate movements may come from “misinterpretation of

some newer out-of-sample test statistics for nested models,

over-reliance on asymptotic out-of-sample test statistics

and failure to check for robustness to the time period sam-

pled.” In particular, they argue that the test suggested by

Clark and West (2007) is more likely to test whether the

Journal of Forecasting. 2019; :699–713. wileyonlinelibrary.com/journal/for ©2019 John Wiley & Sons, Ltd.

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