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

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8.2 Models for Exchange Rate Predictability

In this section, we review the empirical models that we use for evaluating exchange rate predictability. We begin by describing the Engel and West (2005) present value model that nests and motivates many of the predictive regressions we estimate.

8.2.1 A Present Value Model for Exchange Rates

The Engel and West (2005) model relates the exchange rate to economic fundamentals and the expected future exchange rate as follows:

8.1 8.1

where st is the log of the nominal exchange rate defined as the domestic price of foreign currency, fi, t (i = 1, 2) are the observed economic fundamentals, and zi, t are the unobserved fundamentals that drive the exchange rate. Note that an increase in st implies a depreciation of the domestic currency. This is a general asset pricing model that builds on earlier work on pricing stock returns by Campbell and Shiller (1987, 1988) and West (1988).

Iterating forward and imposing the no-bubbles condition leads to the following present value relation:

8.2 8.2

Engel and West (2005) show that the exchange rate will follow a RW if the discount factor b is close to 1 and either (i) images and f2, t + z2, t = 0 or (ii) . Some other well-known ...

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