Extracting Forward Rate Term Structure Information in Foreign Exchange

Abstract

The difficulty of beating the random walk in forecasting spot foreign exchange rates is well documented, with the restricted VECM of Clarida and Taylor (1997) providing the primary challenge. We seek to extract the informational content of the forward rate term structure through the implementation of a functional principal component-based scalar response model. Our out-of-sample framework leads to near systematic outperformance in terms of a direct comparison of performance measures, versus both the VECM and random walk. The results indicate that the forward rate term structure contains statistically significant information about the evolution of the spot exchange rate.