Predicting Foreign Exchange Directional Moves

Abstract

Researchers have documented that economic fundamentals provide poor predictions of future exchange rates. The authors ask instead how well basic models of foreign exchange determination predict the direction of future exchange rate changes. The forward rate is consistently a poor predictor of the direction of the future spot exchange rate across different currencies, time periods, and term lengths. The authors also find, however, that after 1984, a purchasing power parity equilibrium exchange rate predicts the future direction of the spot rate quite well. This is especially the case when the equilibrium exchange rate implied by purchasing power parity diverges strongly from the spot rate. These results indicate that investors should pay attention to purchasing power parity exchange rates as indicative of future directional changes in exchange rates.