Can the EUR/USD, AUD/USD and CAD/USD Be Predicted Using Financial Stress Index?

Abstract

The purpose of this paper is to investigate if the St Louis Federal Financial Stress Index (STLFSI) can be used to predict the EUR/USD, AUD/USD and CAD/USD. Building on Gurrib (2018) who proposed a unified financial condition index and tested the predictability of the index on major foreign currency markets, this paper extends the analysis further allowing a comparison between the forecasts of the most actively traded currencies, tests for the model efficiency, and analyzes the actual and forecasted foreign currency values of the predicted model. Using weekly data over 1993-2018, and 1-week and 2-weeks ahead forecasts, the EUR/USD had the smallest normalized mean squared errors, with a significant p value of the index and homoscedasticity. Although series were stationary, the results were mixed across different currencies when lags were increased. The forecasted values were higher than the actual foreign currency values during the 2008-2009 crisis, and vice versa during the 2000-2002, explained by the STLFSI spiking up during the 2008-2009 event compared to the 2000-2002 events. The lower and upper band level under the 95% prediction interval, however, captured the effect of the global financial crisis of 2008-2009 and 2000-2002 events.