EVALUATING THE PREDICTIVENESS AND PROFITABILITY OF FOREIGN EXCHANGE RATE FORECASTING MODELS

Abstract

This paper evaluates the performance of two competing currency models as a forecasting and trading tool in fund management. A dynamic vector error correction model is utilized to construct a currency forecasting and fair value forecasting model for the Euro-Dollar exchange rate. Emphasis is placed on robustness testing model performance by changing its specification and how both models perform across different time periods. Based on the accuracy of the forecasts the fair value model outperforms the currency forecasting model; a finding that is not supported using directional forecasts. This is robust to changes in model specification and across different time spans that cover pre-and current financial crisis periods. It is also discovered that the evaluation criteria used and prevailing market conditions determines whether model performance translates into value added in a currency fund.