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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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8.1 Introduction

Exchange rate fluctuations are regularly monitored with great interest by policy makers, practitioners, and academics. It is not surprising, therefore, that exchange rate predictability has long been at the top of the research agenda in international finance. Starting with the seminal contribution of Meese and Rogoff (1983), a large body of empirical research finds that models that depend on economically meaningful variables do not provide reliable exchange rate forecasts. This has led to the prevailing view that exchange rates follow a random walk (RW) and hence are not predictable, especially at short horizons.

Several well-known puzzles in foreign exchange (FX) are responsible for this view. First, the “exchange rate disconnect puzzle” concerns the empirical disconnect between exchange rate movements and economic fundamentals such as money supply and real output (Cheung et al., 2005; Mark, 1995; Rogoff and Stavrakeva, 2008). Second, the “forward premium puzzle” implies that on average the interest differential is not offset by a commensurate depreciation of the investment currency, which is an empirical violation of uncovered interest rate parity. As a result, borrowing in low interest rate currencies and investing in high interest rate currencies forms the basis of the widely used carry trade strategy in active currency management (Brunnermeier et al., 2009; Burnside et al., 2011; Fama, 1984; and Della Corte et al., 2009). Third, there is extensive evidence ...

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