Review of Financial Economics 16 (2007) 305 – 320

www.elsevier.com/locate/econbase

A portfolio balance approach to the Canadian–U.S. exchange rate

David O. Cushman ⁎
Department of Economics, University of Saskatchewan, Canada
Department of Economics and Business, Westminster College (PA), USA
Received 15 January 2006; accepted 30 June 2006
Available online 28 September 2006

Abstract

An empirical portfolio balance model based on Branson and Henderson [Branson, W. H., & Henderson, D. W.
(1985). The specification and influence of assets markets. In: Jones R. W., Kenen, P. B. (Eds.), Handbook of
International Economics, Volume 2, Elsevier, Amsterdam] is specified for the Canadian–U.S. exchange rate over
the floating exchange rate period. Empirical implementation reveals two cointegrating vectors that closely,
although not perfectly, match the home and foreign asset demands of the theoretical model. Furthermore, the
exchange rate is important in the error correction process. Finally, although the significance is quantitatively and
statistically modest, a simplified version of the empirical model resulting from general-to-specific procedures is
able to beat a random walk at some out-of-sample forecast horizons.
© 2006 Elsevier Inc. All rights reserved.

JEL classification: F31; F37; F47

Keywords: Exchange rate determination; Portfolio balance model; Cointegration; Out-of-sample forecasting

1. Introduction

Success in explaining floating exchange rates with empirical exchange rate models based on
fundamentals has been limited, as discussed by, for example, Frankel and Rose (1995) and Cheung,
Chinn, and Pascual (2005). Monetary and purchasing-power-parity models have received the most
attention, but they have usually produced model-inconsistent parameter estimates or poor out-of-sample
forecasts. Cheung et al. (2005) broaden the search by investigating five empirical models, most of which

⁎ Department of Economics and Business, Westminster College (PA), USA.

E-mail address: cushmado@westminster.edu.

1058-3300/$ - see front matter © 2006 Elsevier Inc. All rights reserved.
doi:10.1016/j.rfe.2006.06.001
306 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320

are based on fundamentals but not all of which are monetary. Still, none of their models fare consistently
well under a variety of criteria, except for out-of-sample forecasting where modest success at longer
horizons is occasionally achieved.1
The portfolio balance model is an exchange rate model based on fundamentals for which focused
treatments are few in number and not recent on average. This and the fluctuating fortunes of other
structural models suggest that more attention be paid to empirical analysis of the portfolio balance
model. I do so in the present paper with an application to the Canadian–U.S. exchange rate, which has
been particularly resistant to explanation using standard monetary fundamentals (Cushman, 2000;
Faust, Rogers, & Wright, 2003; Mark, 1995).
The central assumption of portfolio balance models is that assets in different countries are not
perfect substitutes. The exchange rate enters through valuation effects in the supply and demand for
assets, and a risk premium appears in the interest parity condition. Purchasing power parity is not
assumed.
Empirical results for portfolio balance effects have been mixed. Investigations that focus on asset
supplies but find little support include works by Branson, Haltunen, and Masson (1977), Frankel
(1983), and Golub (1989). Bisignano and Hoover (1982), using bilateral Canadian–U.S. data, find a
bit more support. Frankel (1984) reports exchange rate effects, consistent with the theory, from asset
based risk-premium variables in a monetary-portfolio-balance synthesis. Kearney and MacDonald
(1986) and Dominguez and Frankel (1993) report effects from sterilized intervention, thus indirectly
supporting the portfolio balance model. Obstfeld (1983) does not find such effects. Black and Salemi
(1988) achieve some success in relating asset balances to the estimated variance–covariance matrix
of unexpected exchange rate changes. Blundell-Wignall and Browne (1991) and Cushman, Lee, and
Thorgeirsson (1996) find effects from cumulative current account balances, which could reflect
portfolio balance effects. But Faust et al. (2003) do not find that such a term improves out-of-sample
forecasting when added to the monetary model. Hau and Rey (2004) do report results consistent
with portfolio effects in a model of equity returns, equity flows, and exchange rates. Finally, the
composite model of Cheung et al. (2005), which includes two portfolio balance asset variables, is
not one of their better performing models. Thus, Hallwood and MacDonald's overall conclusion, that
“empirical studies on the portfolio balance approach are not particularly supportive of the model,”
remains apt (Hallwood & MacDonald, 2000, p. 246).
I try to improve on this record by using a more complete portfolio model with better asset data than in
many of the above papers. I also account for the nonstationarity of the data by using cointegration
procedures developed after many of the above papers were written. 2 The data are quarterly from 1970:3
(the first full quarter of the Canadian dollar's float) through 1999:4. I find cointegration among the
portfolio balance model's variables, and the cointegrating vectors are broadly consistent with theoretical
expectations. A simplified model resulting from general-to-specific procedures marginally beats the
random walk at some out-of-sample forecast horizons.

1
See Breuer (1994) for an earlier effort to broaden the search beyond standard monetary factors. For further discussion of the
monetary model, see Rogoff (1999) for a pessimistic view and MacDonald (1999) for a more optimistic view. See also
MacDonald and Taylor (1994), Chinn and Meese (1995), Mark (1995), MacDonald and Marsh (1997), Kilian (1999), Cushman
(2000), Berkowitz and Giorgianni (2001), Mark and Sul (2001), and Faust et al. (2003).
2
An unpublished paper by Peever (1998) represents an early application of cointegration tests to Frankel's (1983)
specification.
 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320 307

2. Specification of a basic portfolio balance model

The empirical work of the present paper is motivated by a specification in Frankel (1983) and a
modification of it. 3 The Frankel (1983) specification can be derived from the “general specification” of
Branson and Henderson (1985). The latter is a two-country model with four assets, which are the two
countries' bonds (or securities) and money. Similar to Branson and Henderson (1985), several
assumptions can be applied: (1) the residents of each country do not hold the other country's money; (2)
money demand in one country is not a function of the other country's bond return; (3) money demand is
independent of nominal wealth; (4) money demand is unit elastic with respect to nominal income; (5)
home and foreign bond demands are unit elastic with respect to non-monetary nominal wealth; and (6)
with respect to returns, bond demands depend only on the interest differential. 4 The asset demands and
wealth constraints are thus:
Mcan ¼ acan ðiÞY ; Nus ¼ aus ði ⁎ÞY ⁎; ð1a; bÞ

Bcan ¼ bcan ði−i4−EDsÞðWcan −Mcan Þ; Bus ¼ bus ði−i ⁎−EDsÞðWus −Nus Þ; ð2a; bÞ

SFcan ¼ ½1−bcan ði−i⁎−EDsÞðWcan −Mcan Þ; SFus ¼ ½1−bus ði−i ⁎−EDsÞðWus −Nus Þ; ð3a; bÞ

Wcan ¼ SFcan þ Bcan þ Mcan ; Wus ¼ SFus þ Bus þ Nus : ð4a; bÞ

In these equations, S gives the Canadian dollar price of the U.S. dollar (s gives its log), Bi gives
Canadian securities in Canadian dollars, Fi gives U.S. securities in U.S. dollars, Mi gives Canadian
money, Ni gives U.S. money, and subscript i shows who demands the asset and is either “can” or “us.” Y
and Y⁎ are Canadian and U.S. nominal income, i and i⁎ are the Canadian and U.S. interest rates, and E is
the expectations operator.
In (2a,b) and (3a,b), βcan and βus are increasing functions of the interest differential and are restricted to
values between 0 and 1. Under the assumption of “local asset preference,” βcan > βus. The recursive nature
of model then allows considerable simplification:

S ¼ ðBcan =Fcan Þ½1−bcan ði−i ⁎−EDsÞ=½bcan ði−i ⁎−EDsÞ; ð5aÞ

S ¼ ðBus =Fus Þ½1−bus ði−i ⁎−EDsÞ=½bus ði−i ⁎−EDsÞ: ð5bÞ

3
The portfolio balance model can be traced back at least as far as the seminal contribution by Black (1973).
4
Assumptions (1) through (4) are part of Branson and Henderson's (1985) “basic specification.” Instead of our (5) and (6),
however, they have it that changes in money demand from changes on nominal income are fully matched by changes in the
demand for the same country's securities, and they define the wealth elasticity in terms of total assets.
308 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320

Eq. (5a) and (5b) are the asset demands for each country. Frankel's (1983) specification is a linearized
version of (5a) and (5b):
s ¼ −gcan −dcan ði−i ⁎E−DsÞ þ bcan −fcan ; ð6aÞ

s ¼ −gus −dus ði−i ⁎−EDsÞ þ bus −fus ; ð6bÞ

where (except for the interest rates) the lower case letters indicate log values. Finally, given that s is
an I(1) process, its expected change, EΔs, would be a stationary variable, and can thus be omitted
from the cointegration analysis. Thus, we have an empirical model possessing seven variables and
two equilibrium conditions, one for home investors and one for foreign investors.

3. A modified portfolio balance model

In the above model, a country's asset demand is not affected by its international liabilities, and so
let us now consider a modified model where this is so. Suppose that the proportion of non-monetary
wealth held in home bonds, β, is a function not only of the interest differential but also of non-
monetary wealth net of foreign liabilities. This means that the asset demands (2a,b) and (3a,b) are no
longer unit elastic with respect to wealth (but assume both elasticities are still positive). Eq. (5a) and
(5b) now become
S ¼ Sð½i−i ⁎−EDsð−Þ ; BðþÞ ð−Þ ðFÞ
can ; Fcan ; Bus Þ; ð7aÞ

S ¼ Sð½i−i ⁎−EDsð−Þ ; Fcan

ðFÞ
; BðþÞ ð−Þ
us ; Fus Þ: ð7bÞ

The derivative signs, given in parentheses next to the variables, are derived formally in Appendix A,
since they are not quite as obvious as in (5a) and (5b). If home bonds in both countries have wealth
elasticities greater than one, then the sign of Bus in (7a) is positive and the sign of Fcan in (7b) is negative.
These two signs are reversed if the wealth elasticities are less than one. Consider the elastic case. With
respect to (7a), a rise in Bus reduces Canadian net wealth, decreasing the relative Canadian demand for
Canadian bonds, requiring a depreciation of the Canadian dollar and thus a rise in S. With respect to (7b),
a rise in Fcan reduces U.S. net wealth, decreasing the relative U.S. demand for U.S. bonds, requiring a
depreciation of the U.S. dollar and thus a fall in S. In contrast to the original model of (5a), (5b), (6a), and
(6b), the modified model omits only one variable from each asset demand function.

4. The empirical portfolio balance model

For empirical implementation, I follow Frankel (1983) by defining a country's assets held by its
own residents (bcan and fus) as the country's government bonds held by its own private residents (no
Ricardian equivalence). I measure one country's assets held by the other country's residents (fcan and
 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320 309

bus) using bilateral data in the international investment position accounts. The use of bilateral asset
data is appropriate for a bilateral exchange rate model, as pointed out by Bisignano and Hoover
(1982). Unlike Frankel (1983) and Cheung et al. (2005), for example, I do not rely on cumulative
current accounts with the rest of the world. Finally, the interest rates are treasury bill rates. Complete
definitions and data sources are given in Appendix B.

4.1. The general VAR specification

Because the variables in the portfolio balance model are almost certainly nonstationary, any
equilibrium relationships, such as those in the portfolio balance model, will generate cointegrating
vectors. To detect them, I rely primarily on the procedures of Johansen (1991). One begins by specifying a
general VAR model, which raises several specification issues.
First, the Johansen procedures require that the variables be I(0) or I(1), and not I(2). Interpretation is
eased if all are I(1). Thus, the empirical analysis begins by examining this with univariate tests. To save
space, I do not report the details (they are available in a longer version of the paper available upon request,
Cushman, 2006), but the tests include three of the unit root null and one of the stationarity null. The results
suggest that it is reasonable to model all the variables as I(1) processes with constant drift. 5
Additional specification issues are the deterministic variables to include and the lag length. For the
deterministic variables, I include a constant and seasonal dummies in each equation. Given that the
variables are first difference mean stationary, the constant captures the trend in some of the variables in
levels. The seasonal dummies are included because some of the variables are not seasonally adjusted.
To determine the VAR lag order k (in levels), I apply a multivariate extension of Ng and Perron's
(1995) test-down procedure, starting with lag order 8 and conducting system F tests on the final
lags of unrestricted VARs in levels. 6 Lag order 6 is chosen at the 0.10 level. This model is then
subjected to system and individual-equation tests for serial correlation, heteroskedasticity, normality,
and structural stability, all found in PcGive 10.3 (see Doornik & Hendry, 2001). In general, the tests
are passed (details are available in Cushman, 2006). 7

4.2. Cointegration tests

I now apply the Johansen I(1) cointegration procedures. Given the evidence in Reinsel and Ahn
(1992) and Reimers (1992), the trace test statistics for the nulls of various numbers of cointegrating

5
Generally, the unit root is accepted and stationarity rejected for the variables in levels, and the unit root is rejected and
stationarity accepted for the variables in first differences. However, i⁎ could be stationary in levels, because one test rejects the
unit root in levels at the 0.05 level. If stationary, i⁎ would generate its own cointegrating vector. Meanwhile, the unit root null
cannot be rejected for fus in first differences, suggesting that fus might be I(2) in levels. But the stationarity null cannot be
rejected for fus, in first differences, either, suggesting that fus could be I(1) after all.
6
The chi-square likelihood ratio test incorporates the small-sample correction of Sims (1980).
7
Exceptions to the general conclusion exist in the form of possible serial correlation in the fcan and bus equations. But the
situation seems no worse than one deemed acceptable by Juselius (1995), where two of the five equations show a significant
result at or very near the 0.05 level. Also, some tests in the present paper suggest that in two equations the residuals violate
normality with excess kurtosis. However, Johansen (1995) argues that this is not a serious problem for his cointegration test.
Finally, in view of the concerns raised by Candelon and Lütkepohl (2001), I bootstrap the system Chow breakpoint tests of
structural stability.
310 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320

vectors are adjusted by multiplying by a degree of freedom adjustment (T − pk)/T, where p is the
number of variables and T is sample size after conditioning on lags.8 The Johansen trace test is among
the best performing of a large number of systems cointegration tests investigated by Hubrich,
Lütkepohl, and Saikkonen (2001) for both size and power.
The trace test results for the nulls of 0 through 6 vectors are: 126.28, 91.28, 58.70, 33.82, 16.18,
5.88, and 0.00. From the tables in Hansen and Juselius (1995), the p-values for the first three are
0.032, 0.079, and 0.246.9 Thus, it can be concluded that there are one or possibly two cointegrating
vectors. Although accepting two vectors relies on a p-value somewhat in excess of 0.05, the
consistency of two vectors with the theoretical model, where there are the two asset equilibrium
conditions, argues in favor of including the second vector in the empirical model.10 Furthermore, a
variation of the Johansen test by Lütkepohl and Saikkonen (2000) clearly indicates two vectors at
the 0.05 level, using critical values from Trenkler (2003) and the degree-of-freedom correction. 11
Therefore, let us consider the first two estimated vectors, which are given in Table 1. The significance
of each variable in the cointegration space can be determined by the chi-square “exclusion test.” The
bootstrapped results of Cushman et al. (1996) and Cushman (2000) suggest that the same degree-of-
freedom correction applied to the trace test is also reasonable for this test. Thus, I make the adjustment
here. The results in Table 1 show that each variable is significant at the 0.05 level, except for i, significant
at the 0.10 level. The coefficients and their signs, however, are harder to evaluate because, although they
have each been normalized on the exchange rate, the estimated vectors are unidentified and therefore need
not individually resemble the underlying demand equations, Eq. (6a) and (6b) or (7a) and (7b).
Nevertheless, Table 1 gives the signs expected based on the basic model's Eq. (6a) and (6b), or the
modified model's Eq. (7a) and (7b) under the assumption that both countries have wealth elasticities
greater than one for home bonds. But recall that each equation omits one or two asset variables for
holdings of the other country, depending on the model. Anyway, all four interest rate coefficient signs and
five of the eight asset coefficient signs are consistent with the expected signs as given in Table 1.
I next test some vector constraints suggested by the theoretical models. These are all chi square
tests, but I am not aware of evidence concerning the application of a degree-of-freedom correction for
them, although I suspect it is reasonable. Thus, I continue to use it. The first test is whether the
interest rate coefficients are equal but opposite in sign in the two vectors and is χ2 (2). The value is
6.675 with a p-value of 0.036. The restriction is thus rejected, but this is not a particularly bad
indictment of the portfolio balance model, because the equality restriction is only my assumption (6)
and is not necessarily required in such models (see Branson and Henderson, 1985). Moreover, the
Canadian interest rate coefficients are larger (in absolute value) than the corresponding U.S.
coefficients, consistent with local asset preference.
Next, the χ2 (2) statistic for the test that bcan and fcan can be omitted from one vector and bus
and fus from the other (as in Eq. (6a) and (6b) for the basic model) is 8.963 with a p-value of

8
Each trace test statistic tests the null of r or fewer cointegrating vectors. Further evidence on the importance of the degree-of-
freedom correction is found in Cheung and Lai (1993), Gregory (1994), Cushman et al. (1996), and Cushman (2000).
9
The λ-max test results, which suggest similar answers, are not given here because Doornik, Hendry, and Nielson (1999)
report that they are inconsistent.
10
This sort of justification follows Juselius (1999).
11
See Cushman (2006) for details. Similar to the Johansen test, this one performs well in Hubrich et al. (2001).
 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320 311

0.011. This, then, rejects the specific country asset demand functions formulated above in the basic
model. 12
The final two columns of Table 1 show the two estimated unconstrained cointegrating vectors
reformulated as in Section 3's modified portfolio balance model by omitting one asset variable in each
vector. This is a reduced form solution for the two vectors and is identified, but is not a restriction on the
cointegration space relative to the first two columns of Table 1, and so there is no test. There is only one
wrong sign among the eight coefficients with unambiguous sign expectations. The next-to-last vector in
the table looks (almost) like U.S. demand (7b), and the last vector looks like Canadian demand (7a). In
addition, the coefficient for bus in the first vector and fcan in the second have signs are consistent with
wealth elasticity of demand for home (i.e., local) assets greater than one in both countries. Thus, the
reduced forms show that the cointegration space identified by the initial vectors is fairly consistent with
my modified portfolio balance model. Since the two vectors are identified, t-statistics can be calculated
for each coefficient (except the normalized ones for s). These are not shown, but each one indicates
significance at the 0.05 level, regardless of any degree-of-freedom correction. The large number of correct
signs for the portfolio balance model here contrasts significantly with the large number of incorrect signs
for the monetary model for Canada in Cushman (2000).13

4.3. Error correction

Cointegration in the VAR implies the existence of an error correction process, and its coefficients (the
“loadings”) estimated by the Johansen procedure can now be analyzed. The coefficients associated with
the initially estimated but unidentified vectors are given in Table 2 for two normalizations. The standard
normalization for the two vectors is given in the first two columns. This gives the adjustment per time
period of each variable to a unit deviation of the log exchange rate from its equilibrium as defined by the
corresponding estimated cointegrating vector. The sign should match that of the corresponding vector
coefficient if the variable's adjustment is to diminish the disequilibrium with respect to that vector.
Coefficients that do so are indicated in the table. The alternative normalization in Table 2 shows the
proportion of the disequilibrium eliminated per time period by the adjustment in that variable. The
given variable's adjustment will restore equilibrium faster if it has a bigger coefficient in the vector, and so
the second normalization is to multiply the standard adjustment coefficient by the absolute value of its
corresponding coefficient in the vector.14
Table 2 also shows the chi square statistics for the joint significance of each variable's pair of
adjustment coefficients. Based on Cushman et al. (1996), the degree-of-freedom correction is

12
Another restriction follows from the possibility of a stationary U.S. interest rate mentioned in a previous footnote. In this
case and if there are two vectors, the U.S. interest rate would determine one vector and some combination of the remaining
variables would determine the other vector. This restriction is, however, firmly rejected, with a χ2(5) statistic after the degree-
of-freedom correction of 17.793, significant at the 0.01 level.
13
Given cointegration, Hansen and Juselius (1995) provide another specification test, the “beta-constancy test.” The null is the
constancy of the coefficients of “known” or full-sample vectors relative to those of various subsamples. The test is applied
recursively, but in preliminary investigation I found it to be quite oversized, to the same degree as Candelon and Lütkepohl
(2001) find for the system Chow breakpoint test. Thus, I bootstrap the test. For the portfolio balance model, the null of vector
stability cannot be rejected at the 0.05 level. Details are available in Cushman (2006).
14
The first normalization shows whether the adjustment in the variable itself is large or not. The second shows whether that
adjustment (whatever its magnitude) eliminates much of the disequilibrium.
312 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320

Table 1
The cointegrating vectors
Variable Unconstrained Exclusion Reformulated (reduced form)
(exp. sign) Vector 1 Vector 2 test χ2(2) Vector 1 Vector 2
s −1.000 − 1.000 8.340⁎⁎ − 1.000 −1.000
i (−) −1.224 − 3.734 4.916⁎ − 2.418 −12.723
i⁎ (+) 2.080 9.404 7.720⁎⁎ 5.562 35.629
bcan (+) −0.468 0.516 8.816⁎⁎ 4.040
fcan (−) −0.581 − 1.740 7.935⁎⁎ − 1.132 −5.891
bus (+) 0.718 1.133 8.429⁎⁎ 0.916 2.619
fus (−) 0.719 0.562 9.608⁎⁎ 0.644
Significant results for the exclusion tests are highlighted with (⁎) for the 0.10 level and (⁎⁎) for the 0.05 level.

applied. The fcan and bus adjustment coefficients are significant at the 0.05 level. The s adjustment
coefficient is almost significant at the 0.05 level. Thus, these three variables are not weakly
exogenous with respect to the long-run parameters. Unfortunately, the sign of the larger bus
adjustment coefficient is wrong. However, in terms of eliminating disequilibrium (the second
normalization), s and fcan have the largest coefficients and they are of correct sign. The importance
of the exchange rate adjustment is reasonable, given flexible exchange rates. Meanwhile, the
statistical insignificance of interest rate adjustment is consistent with interest rates being controlled
by central banks without regard to equilibrium in the portfolio balance model. The final two
columns of Table 2 give the error correction coefficients that result from reformulating the vectors in
Table 1. The t-statistics for the individual coefficients (not shown to save space) generally confirm
the exclusion tests and additionally indicate that the correctly signed coefficient for fcan is
significant, while the incorrectly signed one is not.

4.4. Out-of-sample forecasts

Ever since Meese and Rogoff 's (1983) paper, an important criterion for empirical exchange rate
models has been out-of-sample forecasting ability. Comparison of a structural model's out-of-sample
forecasts with those of a simple random walk has been the norm. Therefore, I conclude the analysis by
subjecting the empirical portfolio balance model to this classic test.
The basic procedure, as in Mark (1995), Faust et al. (2003), and others, is to compare the empirical
model's out-of-sample root mean square error (RMSE) with that of a random walk. Here, the cointegrated
VAR is estimated for each of 37 subsamples and used to compute out-of-sample forecasts of from 1 to
16quarters from each subsample. The number of subsamples comes from an algorithm in Hansen and
Juselius (1995). With T as the final observation in the data set, the shortest subsample ends with
observation T − 37. Let this be denoted by t0. The subsample's estimated cointegrated VAR is used to get
forecasts for periods t0 + 1 through t0 + 16. The forecasts that are more than one quarter ahead are dynamic
because forecasted values for periods (t0 + 1) through (t0 + k − 1) are used to forecast period (t0 + k). It is of
course also necessary to forecast all the variables to forecast the exchange rate. This adds to the challenge
because poor forecasts of some of the other variables could adversely affect the exchange rate forecast,
even if the exchange rate equation in the VAR is itself well specified. Meanwhile, the random walk
forecast for period (t0 + k) is st0, or (st0 + k c) if drift c is estimated and included.
 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320 313

Table 2
Error correction coefficients
Variable Std. normalization Alt. normalization Excl. test Reformulated
Vector 1 Vector 2 Vector 1 Vector 2 χ2(2) Vector 1 Vector 2
s −0.150 −0.029 − 0.150 −0.029 5.589⁎ −0.193 0.014
i 0.008 0.029 0.010 0.108 0.708 0.034 0.003
i⁎ −0.010 0.038 − 0.021 0.357 1.701 0.022 0.006
bcan −0.200 −0.024 − 0.094 −0.012 3.379 −0.245 0.020
fcan 0.181 −0.130 0.105 −0.226 8.213⁎⁎ 0.089 − 0.038
bus −0.148 0.004 − 0.106 0.004 6.935⁎⁎ −0.162 0.018
fus 0.071 0.034 0.051 0.019 1.132 0.109 − 0.004
Significance is highlighted as in Table 1. Also, boldface–italic means the sign is consistent with the vector coefficient in Table 1
(whether or not that sign is correct). Italics in the final two columns highlight coefficients for which sign consistency is not
relevant, because the corresponding variables are not in the given reformulated vector.

For each model, the out-of-sample forecasts are then recalculated for the subsamples ending in
periods (t0 + 1), (t0 + 2), etc. We thus obtain 37 one-quarter-ahead forecasts, 36 two-quarter-ahead
forecasts, and so on down to 22 16-quarter-ahead forecasts. For each forecast horizon, the ratio of the
RMSE of the empirical model to the random walk model is calculated. If the ratio is less than 1, the
exchange rate model “beats” the random walk. The statistical significance of this is assessed with the
statistic of Diebold and Mariano (1995), denoted by DM. DM is the difference between the two
RMSEs divided by a standard deviation term and is asymptotically normal. The test is lower one-sided.
I bootstrap it as in Mark (1995) and Faust et al. (2003). I also use the bootstrap simulations to generate
distributions of the RMSE ratios.
In their comparisons, Mark (1995) and Faust et al. (2003) use the random walk without drift. Faust et
al. (2003, p. 41) remark that a random walk without drift is harder to beat than a random walk with drift.
However, the Canadian–U.S. dollar exchange rate has had a pronounced trend over the entire estimation
period, and so I do the comparison with both.15
As noted by Meese and Rogoff (1983), a highly parameterized model such as the complete
cointegrated VAR is unlikely to forecast well. My initial efforts with this model bore that out. Thus, I
turn to a parsimonious version. The method is to apply general-to-specific modeling procedures
(Hendry, 1995) to each equation of the full-sample cointegrated VAR, with two of the variables being
the lagged errors from the two cointegrating vectors. In my basic experiment, they are the standard
vectors estimated by the Johansen technique, the first pair of vectors in Table 1. The general-to-specific
idea is then implemented by using the automated procedures in the PcGets 1.0 computer program
(Hendry & Krolzig, 2001) set to generate a relatively parsimonious model. 16 The exchange rate
equation of this model is:
Dst ¼ −0:314 −0:080E1;t−1 ; ð8Þ
ð−3:48Þ ð−3:52Þ

15
Engel and Hamilton's (1990) work provides an example of using both where the driftless random walk is superior to one
with drift (and to their exchange rate model).
16
The PcGets “conservative” setting is used. The general-to-specific approach is not without critics (e.g., Faust & Whiteman,
1997). However, Hoover and Perez (1999) conclude that it avoids many of the criticisms of data mining.
314 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320

where t-ratios are in parentheses and E1,t−1 is the lagged error from the first vector. It seems favorable to
the portfolio balance model that in this equation the exchanges rate's response to estimated
disequilibrium in the portfolio balance model survives a reduction that has eliminated almost every
other parameter. (The other equations are not generally reduced as much.)
An alternative experiment applies the same procedure using the reformulated vectors in Table 1. This
leads to a somewhat more complex equation for Δst:
⁎ −0:361Dit−2
Dst ¼ −0:403 −0:089E1;t−1 −0:428Dit−1 ⁎ −0:206Dfus;t−2 : ð9Þ
ð−3:95Þ ð−4:00Þ ð−3:08Þ ð−2:79Þ ð−3:04Þ

This experiment is implemented because it uses the identified vectors that specifically correspond to
the modified portfolio balance model. Now, if the model reduction always kept both vectors, then the
result would be the same, because the process would involve the identical cointegration space. But, since
the reduction need not keep both vectors in an equation, and, for example, keeps only one in the exchange
rate equation, the choice of vector pair does matter.
The DGP for the bootstrapping the DM statistic and RMSE ratio is estimating using the parsimonious
VAR specification minus the error correction, except for the exchange rate, where it is simply a random
walk with or without drift, depending on the random walk model used for the comparison. Thus, the DGP
captures some of the factors apparently driving the variables, but also imposes the null hypothesis of the
random walk model for the exchange rate.
Table 3 gives the results for the RMSE ratio and DM statistic; only forecast horizons 1, 4, 8, 12, and 16
are reported, as in other papers.17 The bootstrapped p-values are given for the RMSE ratio and DM
statistic, and the asymptotic one as well for DM (these are one-sided tests). Often, the bootstrapped p-
values are more significant than the asymptotic ones. This probably reflects that, under the null, it is very
hard for a model with more parameters to even match on average the correct random walk model that has
with fewer. Thus, in a relatively small sample, it is more of an accomplishment for the empirical model to
do so that the asymptotic distributions indicate.
The basic experiment involving Eq. (8) is reported in Table 3a. The parsimonious portfolio balance
model beats the random walk, with or without drift, at every horizon except the first. According to the
DM p-values, this is statistically significant at the 0.05 level at horizon 16, except for the asymptotic
p-value for DM when the random walk model includes drift. The success at longer horizons is
consistent with Mark's (1995) results. However, here it is a bit harder for the portfolio balance model
to beat the random walk with drift, rather than without drift, contrary to the comment by Faust et al.
(2003).
The second experiment, with the reformulated vector specification, is reported in Table 3b. Here, the
portfolio balance model seldom beats the random walk. However, with the suspicion that this could be
partly due to the extra dynamics in Eq. (9) versus Eq. (8), I re-did the experiment with the reformulated
vector but with these dynamics dropped. The results are in Table 3, part (c). The suspicion is partly
confirmed, as the portfolio balance model now beats the random walk once again, but the significant
results are now at the shorter horizons, and involve only beating the no-drift random walk. Thus, the
finding that the portfolio balance model can beat a random walk with statistical significance is perhaps a
17
The nonparametric serial correlation correction in the DM statistic incorporates a lag of 20, as in other papers, enough to
account for the overlapping nature of the 16-period-ahead forecasts.
 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320 315

Table 3
Random walk Forecast horizon
model 1 4 8 12 16
(a) Out-of-sample forecast comparisons using the standard vectors
No drift RMSE ratio 1.030 0.916 0.776 0.747 0.730
(0.395) (0.116) (0.080)⁎ (0.107) (0.125)
DM 0.358 − 0.298 −0.709 −0.912 −1.916
(0.411) (0.121) (0.062)⁎ (0.060)⁎ (0.026)⁎⁎
(0.640) (0.383) (0.239) (0.181) (0.028)⁎⁎
Drift RMSE ratio 1.088 0.965 0.810 0.773 0.755
(0.800) (0.315) (0.262) (0.306) (0.340)
DM 1.608 − 0.126 −0.601 −0.814 −1.707
(0.985) (0.316) (0.192) (0.191) (0.138)
(0.946) (0.450) (0.274) (0.208) (0.044)⁎⁎

(b) Out-of-sample forecast comparisons using the reformulated vectors

No drift RMSE ratio 1.021 1.045 1.121 1.074 0.946
(0.211) (0.244) 0.299) (0.247) (0.193)
DM 0.078 0.092 0.190 0.104 −0.069
(0.178) (0.230) (0.279) (0.233) (0.199)
(0.531) (0.537) (0.576) (0.542) (0.473)
Drift RMSE ratio 1.079 1.102 1.170 1.112 0.979
(0.594) (0.457) (0.490) (0.447) (0.400)
DM 0.301 0.200 0.259 0.153 −0.026
(0.503) (0.428) (0.483) (0.449) (0.404)
(0.619) (0.580) (0.602) (0.561) (0.490)

(c) Out-of-sample forecast comparisons using the reformulated vectors (alternative dynamics for st)
No drift RMSE ratio 0.941 0.815 0.820 0.838 0.808
(0.042)⁎⁎ (0.040)⁎⁎ (0.098)⁎ (0.133) (0.145)
DM −0.323 − 0.420 −0.296 −0.218 −0.229
(0.092)⁎ (0.081)⁎ (0.131) (0.162) (0.179)
(0.374) (0.337) (0.379) (0.414) (0.410)
Drift RMSE ratio 0.993 0.859 0.856 0.867 0.836
(0.422) (0.161) (0.288) (0.356) (0.376)
DM −0.039 − 0.317 −0.231 −0.175 −0.189
(0.430) (0.207) (0.304) (0.370) (0.399)
(0.485) (0.376) (0.409) (0.431) (0.425)
P-values are in parentheses (lower one-sided tests). For the RMSE ratio, they are bootstrapped. For DM, the first is bootstrapped
and the second is asymptotic. Significance is highlighted as in Table 1.

delicate one. But even when the portfolio balance model loses, it does not lose badly, as does the monetary
model in, for example, Faust et al. (2003).

5. Conclusions

In this paper, an empirical portfolio balance model based on Branson and Henderson (1985) is specified
for the Canadian–U.S. exchange rate over the floating exchange rate period. Initial testing leads to a
316 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320

general six-lag VAR. Cointegration tests then reveal two cointegrating vectors that closely match the home
and foreign asset demands of one version of the theoretical model. Analysis of the error correction
coefficients then shows that the exchange rate is important in the adjustment to equilibrium, as expected
under flexible exchange rates. Finally, although the significance is quantitatively and statistically modest, a
simplified version of the empirical model resulting from general-to-specific procedures is able to beat a
random walk at some out-of-sample forecast horizons. Although the empirical portfolio balance model
presented here for the Canadian–U.S. exchange rate is not entirely satisfactory, its consistency with
theoretical expectations and its out-of-sample forecasting performance are better than have usually been
found for other fundamentals-based models, particularly of this exchange rate.

Appendix A. The modified portfolio balance model

For the modified model signs, focus on the Canadian asset Eq. (5a), which leads to (7a). Effects in the
U.S. equation would be the same. The implicit function version of (5a) is
  
Bcan 1−bði; wÞ
G¼ −S ¼ 0;
Fcan bði; wÞ

where i is short for (i − i⁎ − EΔs) and the “can” subscript has been dropped from β. Also, w = SFcan + Bcan
− Bus, introducing the effect of net Canadian non-monetary wealth on β.18
First, partial derivatives for the implicit function are:
Fcan bw þ b2
Gs ¼ ;
b2
Gi ¼ −bi =b2 ;
−Bcan bw þ bð1−bÞ
GBcan ¼ ;
Fcan b2
−Bcan ðSFcan bw þ bð1−bÞÞ
GFcan ¼
Fcan b2
−Bcan ðFcan bw þ bð1−bÞÞ
GSFcan ¼ ;
Fcan b2
Bcan bw
GBus ¼ :
Fcan b2

The derivative and sign for the interest differential's effect on the exchange rate is:
AS Gi
¼ − < 0:
Ai Gs

18
Except for “can” and “us,” all subscripts below refer to first partial derivatives.
 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320 317

The sign follows from Gi < 0 (because βi > 0) and Gs < 0. The sign of GS can be deduced as follows.
First, if βw > 0, then the sign is clearly negative. If βw < 0, GS is still negative, as follows. Positive wealth
elasticities for both countries' bonds in either country imply that
ABcan GSFcan
¼− > 0:
ASFcan GBcan
This is the effect on home bond demand of higher net wealth from more foreign bonds given the
exchange rate. If βw < 0, then GBcan > 0, and for GSFcan < 0 (so the derivative is positive) it is required that
|Fcanβw| < β(1 − β). Since 0 < β < 1, then β(1 − β) ≤ β2 , and thus GS is negative.
The derivative and sign for the effect of Bcan on the exchange rate is:
AS GB
¼ − can > 0:
ABcan Gs
This sign follows from Gs < 0 and GBcan > 0. Regarding GBcan, if βw < 0, then GBcan is clearly positive. If
βw > 0, GBcan is still positive from the wealth elasticity assumption, which implies:
AFcan GB
¼ − can > 0;
ABcan GFcan
If βw > 0, then GFcan is clearly negative so GBcan must be positive (it is required that |−Bcanβw| < β(1 − β).
Note that this shows GFcan < 0.
The derivative and sign for effect of Fcan on the exchange rate is:
AS GF
¼ − can < 0:
AFcan Gs
Finally, the derivative and sign for effect of Bus on the exchange rate is:
AS GB
¼ − us :
ABus Gs
Since Gs is negative, the sign depends on GBus, which is the same as the sign of βw.

Appendix B. Data definitions and sources

The asset value variables are not seasonally adjusted. Canadian securities held by Canadian residents
(bcan) are defined as “Canadian government debt held privately” net of “Canadian government debt
held by nonresidents” (CANSIM B2514 minus B2513).19 U.S. securities held by U.S. residents (fus)
are defined as “federal debt held by private investors” net of “federal debt held by foreign investors”
(Federal Reserve Bank of St. Louis, FRED). Foreign (U.S.) securities held by Canadian residents (fcan)
are defined as Canada's total U.S. assets in Canada's international investment position (CANSIM
D65300) converted to U.S. dollars and net of the Bank of Canada's U.S. dollar reserve assets

19
These are CANSIM I series labels. CANSIM (Canadian Socio-Economic Information Management System) is the Statistics
Canada computerized database.
318 D.O. Cushman / Review of Financial Economics 16 (2007) 305–320

(CANSIM B3801). Canada's total U.S. assets are available only annually. End-of-quarter values were
estimated from cumulations of Canada's net U.S. asset flows (CANSIM D59151) net of official U.S.
dollar reserve asset flows (CANSIM D59159) on the capital and financial account side of the
Canadian balance of payments.20 Home (Canadian) securities held by foreign (U.S.) residents in
Canadian dollars (bus) are defined as Canada's total U.S. liabilities in Canada's international
investment position (CANSIM D65311). These figures are also only available annually, and end-of-
quarter values were estimated from cumulations of Canada's net U.S. liability flows (CANSIM
D59161).
The exchange rate is from the IMF's International Financial Statistics CD-ROM (series 156..RF.
ZF…). The interest rates, also from the IMF, are 3-month treasury bill rates (series 15660C..ZF... for
Canada and 11160C..ZF... for the U.S.

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