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

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8.4 Economic Evaluation of Exchange Rate Predictability

This section describes the framework for evaluating the performance of an asset allocation strategy that exploits predictability in exchange rate returns.

8.4.1 The Dynamic FX Strategy

We design an international asset allocation strategy that involves trading the USD and nine other currencies: the AUD, CAD, CHF, Deutsche mark \ euro (EUR), GBP, JPY, NOK, NZD, and SEK. Consider a US investor who builds a portfolio by allocating her wealth between 10 bonds: one domestic (US), and nine foreign bonds (Australia, Canada, Switzerland, Germany, UK, Japan, Norway, New Zealand, and Sweden). The yield of the bonds is proxied by euro deposit rates. At each period t + 1, the foreign bonds yield a riskless return in local currency but a risky return rt+1 in USD, whose expectation at time t is equal to Et[rt+1] = it + Δst+1|t. Hence the only risk the US investor is exposed to is the FX risk.

In each period the investor takes two steps. First, she uses each predictive regression to forecast the one-period-ahead exchange rate returns. Second, depending on the forecasts of each model, she dynamically rebalances her portfolio by computing the new optimal weights. This setup is designed to assess the economic value of exchange rate predictability by informing us which empirical exchange rate model leads to a better performing allocation strategy.

8.4.2 Mean-Variance Dynamic Asset Allocation

Mean-variance analysis is a natural framework for assessing ...

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