strongExchange Ratesstrong Forecasting Model An Alternative Estimation.doc

Exchange Rates Forecasting Model: An Alternative Estimation Procedure Ahmad Zubaidi Baharumshaha, Liew Khim Sena and Lim Kian Pingb aFaculty of Economics and Management, Universiti Putra Malaysia bLabuan School of International Business and Finance, Universiti Malaysia Sabah Abstract We propose an alternative procedure for modelling exchange rates behaviour, which is a linear combination of a long-run function and a short-run function. Our procedure involves modelling of the long-run relationship and this is followed by the short-run function. Among all the possible combination of modelling techniques, we proposed the simplest form, namely modelling the long-run function by the well established purchasing power parity (PPP) based model and setting up the short-run function based on its time series properties. Results of this study suggests that our procedure yields powerful forecasting models as they easily outperform the simple random walk model--which is rarely defeated in the literature of exchange rate forecasting--in term of out-of-sample forecasting, for all the forecast horizons ranging from one to fourteen quarters. This study provides us with some hope of achieving a reasonable forecast for the ASEAN currencies using the fundamental monetary model just by a simple adaptation. Keywords: Exchange rate, purchasing power parity, adapted model, forecasts 1. Introduction Most currency exchange rate markets in the floating exchange rate regime have experienced continuous and sometimes dramatic fluctuations and volatility. The broad features of exchange rate behaviour are summarized in a widely cited paper by Mussa (1996). In this paper, Mussa argued that (i) exchange rate are extremely volatile, with deviation of about 3 percent per month for the US dollar-Japanese yen and US dollar-Deutschemark rates; (ii) changes in exchange rates are very persistent, and the exchange rate closely approximate a random walk; (iii) there is correlation of almost unity between