Emerging Markets Review: Paresh Kumar Narayan, Susan Sunila Sharma, Dinh Hoang Bach Phan, Guangqiang Liu T

Emerging Markets Review 42 (2020) 100668
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Emerging Markets Review

journal homepage: www.elsevier.com/locate/emr
Predicting exchange rate returns

T
Paresh Kumar Narayana, Susan Sunila Sharmab, Dinh Hoang Bach Phanc,
⁎
Guangqiang Liud,
a
Centre for Financial Econometrics, Deakin University, Burwood, Australia
b
Department of Finance and Centre for Financial Econometrics, Deakin University, Burwood, Australia
c
La Trobe Business School, La Trobe University, Melbourne, Australia
d
School of Accounting, Zhongnan University of Economics and Law, Wuhan, China
A R T IC LE I N F O ABS TRA CT
Keywords: We test whether forward premiums predict spot exchange rate returns for 16 currencies. We
Exchange rate apply a recently developed time series predictability test that allows us to model data features
Forward premium including heteroskedasticity in forward premium. We discover return predictability for 75% (12/
Heteroskedasticity 16) of currencies in our sample. Trading strategies show that investors can make more profits
Persistency
from our proposed forward premium model compared to a random walk model and foreign
Endogeneity
exchange carry trade model.
Predictability
1. Introduction
Meese and Rogoff's (1983a, 1983b) found that standard empirical exchange rate models could not out-perform a simple random
walk model (RWM). This finding motivated a stream of research. One strand of this literature, commonly referred to as the unbiased
efficiency hypothesis, examines whether forward rate premium is the optimal unbiased predictor of future spot exchange rate
changes. Empirical evidence, dating back to works of the 1980s, suggests that the forward rate is not a predictor of the future spot
exchange rate. In other words, the forward premium is found not to be an optimal predictor of the rate of depreciation; see, for
instance, Hansen and Hodrick (1980), Frankel (1980), Bilson (1981), and Hsieh (1993).1
Moreover, later studies that found predictability claimed that forward premium negatively predicted exchange rate changes (see
Froot and Thaler, 1990). The negative predictability has not been ignored though. Several theoretical explanations for this empirical
departure from the unbiased efficiency hypothesis have been proposed, and an excellent survey on this can be found in Taylor (1995).
First, Fama (1984) and then Hodrick and Srivastava (1986) contended that the negative slope coefficient is because of a time-varying
risk premium. The work of Froot and Frankel (1989) exposed the role of expectation errors to the negative slope. And, Chakraborty
and Evans (2008) explain the negative slope coefficient based on perpetual learning. Finally, while Cornell (1989) claimed that
measurement errors in the data were responsible, these claims were quickly squashed by Bekaert and Hodrick (1993), who de-
monstrated that measurement errors were not that important. Bansal (1997) showed that the puzzling empirical evidence can be
accounted by a particular term structure model. Finally, some studies argue that the negative sign can be a result of the carry trade
⁎
Corresponding author at: School of Accounting, Zhongnan University of Economics and Law, Wuhan, China.
E-mail addresses: narayan@deakin.edu.au (P.K. Narayan), 71619918@163.com (G. Liu).
1
More recently, Corte et al. (2016) show that currency volatility risk premia predict exchange rate returns. Byrne et al. (2016) use time-varying
exchange rate predictability models and find that such models beat the RWM in the majority cases. These results are supported by the work of Ince
et al. (2016) which undertakes extensive out-of-sample analysis of exchange rate predictability. Moreover, using nonlinear panel data models of
exchange rate Lopez-Suarez and Rodriguez-Lopez (2011) also find strong out-of-sample evidence of exchange rate predictability.
https://doi.org/10.1016/j.ememar.2019.100668
Received 1 August 2019; Received in revised form 6 November 2019; Accepted 5 December 2019
Available online 16 December 2019
1566-0141/ © 2019 Published by Elsevier B.V.
P.K. Narayan, et al. Emerging Markets Review 42 (2020) 100668
strategy (see Brunnermeier et al., 2009; and Menkhoff et al., 2012).

The debate has, thus, raged on why the forward premium negatively predicts the rate of depreciation. The answer to this question
has direct implications for economic models, such as the capital asset pricing model (CAPM) (see Mark, 1988) and the consumption
and money-based general equilibrium models (see Bansal et al., 1995; Backus et al., 1993; Bekaert, 1996). However, purely from an
investor's point of view, the fact that exchange rate is predictable points to opportunities for making profits. Initially, there was a
concern that since the forward premium negatively affects future exchange rate changes, effectively an exchange rate appreciation,
the forward premium is unlikely to contain useful information for investors (see Cumby and Obstfeld, 1984). This view was chal-
lenged and overturned by Clarida and Taylor (1997), who note that if forward rate fails to predict the future spot rate, it does not
really imply that forward rates do not contain valuable information for forecasting future spot exchange rate.2 More specifically, they
note (p. 354): “… while the forward premium (the difference between the forward rate and the current spot rate) typically explains
only a tiny fraction of subsequent exchange rate movements (as measured by the R2) and the estimated slope coefficient is typical of
the opposite sign to that suggested by the risk-neutral efficient markets hypothesis (RNEMH), the estimated slope coefficient is
nevertheless often statistically significantly different from zero … This suggests that there is important information in the term
structure, which can be extracted”. And, rather fittingly, Clarida and Taylor (1997, p. 361) write that: “Further empirical work might
be addressed toward establishing the robustness of these conclusions”.
Over a decade later, Corte et al. (2009) attempted to provide further evidence on the economic significance of forward premiums
and, in so doing, provide the most recent update on the existing gap in the literature (p. 3497): “… little attention has been given to
the question of whether the statistical rejection of the Uncovered Interest Parity and the forward bias resulting from the negative
estimate of β offers economic value to an international investor facing FX [foreign exchange] risk”. From Clarida and Taylor (1997) to
Corte et al. (2009), the message remains clear: additional empirical work is needed to establish the economic significance of forward
premiums. We take a position in this literature and undertake an extensive investigation of the economic significance of forward
premiums.
Our objective is to test for exchange rate predictability using the forward premium as the predictor variable. We use historical
daily time-series data for no fewer than 16 currencies. In this regard, our paper is like the work of Corte et al. (2009). However, there
are things we do differently from Corte et al. (2009). First, we use relatively high frequency data (daily data) and consider 16
currencies, while Corte et al. (2009) use monthly data and consider only three currencies. This is a significant step because Corte et al.
(2009, p. 3523) request such an analysis by writing: “… our motivation for investigating predictability at the one-month horizon is
founded on the prevailing view in this literature that exchange rates are not predictable at short horizons. It is clear, therefore, that
one possible direction in extending the analysis of this paper is to study the predictability … for higher frequencies and longer
horizons. We leave this for future research”. We discover evidence of exchange rate predictability for no fewer than six countries out
of a possible 16, equivalent to 38% of sampled currencies. We document mixed evidence of predictability in terms of sign; for four
currencies (AUD, INR, PHP, and THB) predictability is positive and for two currencies (GBP and NZD) predictability is negative.
Second, we utilise time-series predictability tests which allows us to model heteroskedasticity in the variables. While Corte et al.
(2009) pay attention to heteroskedasticity by applying a GARCH model, issues of endogeneity and persistency are left for future
research, and we address these issues. Our empirical analysis shows that in addition to variables been persistent and endogenous,
they are also heteroskedastic. These features characterize our daily data set. Therefore, modelling these three salient features of the
data in a coherent manner in predictive regression models is imperative to demonstrate the robustness of the results.
Third, our treatment of predictability is different not only in terms of the large number of countries and currencies we consider,
but also because we use a range of forward premiums reflecting different maturities. We use the 30-day, 90-day, 180-day, and 360-
day forward premiums. This ensures that we are able to check the robustness of the results. Our findings reveal that for the six
countries where predictability is found, they are found regardless of the forward premium maturity date used.
Fourth, we utilise not only statistical measures of the out-of-sample (OOS) predictability but also a trading-based approach to
testing for predictability. Here, we apply the excess predictability (EP) test developed by Anatolyen and Gerko (2005), which ex-
amines the null hypothesis of no mean predictability in OOS profits obtained from a simple trading strategy sufficient to generate buy
and sell signals. We generate profits from a simple trading strategy that takes a long position when predicted returns are greater than
zero, and a short position when predicted returns are less than or equal to zero. The predicted returns are obtained from the (forward
premium model) FPM and compared with those from a RWM and a carry trade model (CTM). This comparison allows us to test for the
mean of no predictability in predicted returns. From this exercise, we discover strong evidence that the null hypothesis of no mean
predictability is rejected in seven (nine) currencies when comparing the FPM with the RWM (CTM), suggesting that profits generated
from the FPM are superior to those generated from these two alternative models.
When we consider both in-sample and OOS evidence of predictability we find that 12 out of 16 currencies are predictability. This
represents 75% of our sample currencies. The four currencies that have no evidence of predictability are CAD, EURO, JPY, and KRW.
Finally, in additional results, we consider an additional 34 currencies. The difference between this sample and our original sample
of 16 currencies is that these 34 currencies are not floating exchange rate regimes over the time period of data considered. In other
words, the exchange rate regime oscillates from fixed to floating over the sample period. While this type of unstable regime behaviour
is not ideal for predictability tests, our investigation reveals that even with such regimes the FPM is able to extract information
leading to profitable trading outcomes that beat the RWM and CTM. These conclusions also hold in robustness tests that, in addition
2
These findings were supported by Clarida et al. (2003) and Nucci (2003), and for an excellent analysis of the exchange rate issues, in particular
on why exchange rate predictability may not hold, see Rossi (2013).
2
to the use of different forward rates and accounting of key statistical features of data, account for the effects of the global financial
crisis.
2. Empirical framework and econometric approach
2.1. Empirical framework—A motivation
There is a history, dating back to the 1980s, reflected in a number of surveys of the literature (see Hodrick, 1987; Engle, 1996;
Taylor, 1995) that the simple risk-neutral efficient markets hypothesis (RNEMH) fails to hold in empirical applications. There are two
fundamental interest parity conditions, namely, the Covered Interest Parity condition (CIP) and the Uncovered Interest Parity (UIP)
condition, which bind the relationship between spot and forward exchange rates. The CIP states that the interest rate differential
between domestic and foreign securities of the same type is simply equal to the relevant forward exchange rate premium. Several
studies have documented strong empirical support for the CIP (see, inter alia, Taylor, 1989, 1995; Popper, 1993; Cho, 2015; Suh and
Kim, 2016; Fukuda and Tanaka, 2017). The UIP, on the other hand, states that the expected rate of nominal exchange rate depre-
ciation is simply equal to the difference in nominal interest rates across countries on the same financial assets. As Isard (1993) makes
it clear, financial assets are in relevant currencies and share common characteristics, such as those relating to maturity and risk.
Clarida and Taylor (1997) show that the empirical framework, whereby the future changes in spot exchange rate are regressed on the
one period lagged forward premium, can be arrived at by combining the CIP and the UIP together with the rational expectations
assumption. It follows that the predictive regression model has the following form:
ERt = α + βFPt − 1 + εt (1)
where ER is the percentage change in the spot exchange rate, computed as (St+1 − St)/St. With each spot price there is a forward
price, denoted ERP. Therefore, we compute the forward premium (FP) as (ERPt − St)/St.
The model we employ, accounts for: (a) biasness in the predictive slope, induced by persistence and endogeneity of the predictor
variable, as shown initially by Stambaugh (1999) and then Lewellen (2004); and (b) persistent, endogenous and heteroskedastic
predictors as proposed by Westerlund and Narayan (2012, 2015a).3
3. Empirical findings
We start this section with and preliminary analysis, followed by formal predictability tests, and concluding with OOS predict-
ability analysis. Here, we focus on both statistical and economic measures.
3.1. Data and preliminary analysis
We have time-series daily data for 16 currencies, namely Australian Dollar (AUD), Canadian Dollar (CAD), Euro (EUR), Indian
Rupee (INR), Japanese Yen (JPY), Mexican Peso (MXN), New Zealand Dollar (NZD), Norwegian Krone (NOK), Peruvian Sol (PEN),
Philippine Peso (PHP), Polish Zloty (PLN), South African Rand (ZAR), South Korean Won (KRW), Swedish Krona (SEK), Thai Baht
(THB), and the United Kingdom Pound (GBP). These currencies are listed in column 1 of Table 1. We also have exchange rate data for
34 other countries as listed in an online Appendix. We do not consider them in the main results of our paper because they have had
different exchange rate regimes over different time periods during the sample period under consideration (see Appendix Table A for
further detail).4 We will return to analysing in detail of these 34 currencies later in Section 4.
For now, we focus on the 16 currencies that have a floating regime. The daily sample period varies by country depending on the
availability of data. The start date for each country is different (see Table 1) and the end date for all currencies considered in the
paper is 30 June 2018. In column 3, we also report the number of data points (observations) per country. It is easy to see the variance
in sample size from this data. There are over 5000 observations for Australia, Canada, Europe, India, Japan, Mexico, New Zealand,
Norway, the Philippine, South Africa, Sweden, Thailand, and the UK and over 3500 for Peru, Poland, and South Korea. On the whole,
we have good time-series data for a predictability test. All data (spot and forward rates) are downloaded from DataStream. All
currencies are the closing price of direct quotes (against USD) reported at the US trading time, except AUD, NZD, and GBP which are
indirect quotes against USD.
We closely examine the data. For this purpose, we focus on exchange rate returns and only one (the 30-day forward rate) of the
four forward rates. Results for the other forward rates are the same so we do not discuss them. These results will be made available on
request. We begin with the mean and standard deviation of the spot exchange rate change and the 30-day forward premium; see
Table 1. When the mean exchange rate is positive it implies a depreciation of the local currency vis-à-vis the USD. This is found to be
the case except for AUD, NZD, and the GBP. AUD, NZD, and GBP are indirect quotes against USD. Over the sample period considered,
14 currencies had depreciated against the USD while the other two (namely PEN and KRW) had appreciated. The largest depreciation
3
For advantages of using this model and applications to alternative datasets, see Sharma (2019), Phan et al. (2019), and Juhro and Phan (2018).
4
We collect information of exchange rate regimes from the “Exchange Arrangements and Exchange Restrictions” annual reports from the
International Monetary Fund (IMF: https://www.imf.org/en/Publications/Annual-Report-on-Exchange-Arrangements-and-Exchange-Restrictions).
We have excluded Taiwanese dollar because IMF does not categorise its regimes over the sample period considered in our study.
3
Table 1
Descriptive statistics
Currency Start date No of Obs. EX FWP-30
Mean SD Mean SD
Australian Dollar (AUD) 12/31/1996 5609 −0.00001 0.00769 −0.00164 0.00578

Canadian Dollar (CAD) 12/31/1996 5609 0.00001 0.00549 0.00003 0.00082
Euro (EUR) 12/31/1998 5088 0.00002 0.00611 −0.00039 0.00111
Indian Rupee (INR) 10/27/1997 5396 0.00012 0.00367 0.00394 0.00229
Japanese Yen (JPY) 12/31/1996 5609 0.00001 0.00676 −0.00204 0.00176
Mexican Peso (MXN) 12/31/1996 5609 0.00019 0.00675 0.00582 0.00492
New Zealand Dollar (NZD) 12/31/1996 5609 −0.00001 0.00805 −0.00223 0.00424
Norwegian Krone (NOK) 12/31/1996 5609 0.00007 0.00735 0.00076 0.00172
Peruvian Sol (PEN) 3/29/2004 3721 −0.00001 0.00305 0.00187 0.00446
Philippine Peso (PHP) 12/31/1996 5609 0.00014 0.00515 0.00323 0.00300
Polish Zloty (PLN) 2/11/2002 4276 0.00001 0.00861 0.00198 0.00183
S. African Rand (ZAR) 12/31/1996 5609 0.00024 0.01016 0.00587 0.00240
S. Korean Won (KRW) 2/11/2002 4276 −0.00002 0.00675 0.00079 0.00158
Swedish Krona (SEK) 12/31/1996 5609 0.00007 0.00721 −0.00029 0.00144
Thai Baht (THB) 12/31/1996 5609 0.00006 0.00554 0.00174 0.00417
UK Pound (GBP) 12/31/1996 5609 −0.00005 0.00567 −0.00080 0.00276
This table reports the start date and sample size of historical time-series daily data for each currency (columns 2 and 3) and the mean and standard
deviation of spot exchange rate returns (EX, see columns 4 and 5) and the 30-day forward premium (FWP-30, see columns 6 and 7).
was experienced by ZAR, followed by MXN, PHP, and INR, while the largest depreciation was experienced by KRW. With respect to
the 30-day forward premium, we notice that in three countries it was negative while in the remaining 13 countries the forward
premium was positive.5 Australia had the most volatile forward premiums, whereas Canada had the least volatile forward premium.
Overall, these simple descriptive statistics imply that we have a very diverse set of countries in our sample. Therefore, a time-series
analysis of exchange rate predictability is appropriate.
We turn now to three issues that matter directly for predictability tests and, indeed, for the choice of the particular type of time-
series predictive regression model. First, let us consider the issue of persistency. We refer now to column 3 of Table 2. Here we have
reported the ADF test.6 A rejection of the null implies zero or little persistency—a condition on which most predictive regression
models are estimated—while the acceptance of the null would suggest otherwise, rendering slope biasness in predictive regression
models. The models allow for 8 lags, which are chosen upfront and then optimized using the Schwarz Information Criterion. This
allows us to control for autocorrelation. The results are reported for exchange rate returns and the 30-day forward premium. We find
no evidence of a unit root in the exchange rate returns, but not for forward premiums. For five currencies, the null is not rejected.
These currencies are EUR, JPY, NOK, PLN, and SEK. Even for the 11 currencies found to be stationary, the autoregressive (AR)
coefficient from an AR(1) model suggests that the coefficient is extremely high and very close to one; the exceptions are AUD, NZD,
and the GBP, where the coefficient is around 0.1 (see column 1). The key implication here is that the usual suspect that the predictor
variable is persistent in predictive regression models is confirmed to be true in our data set.
We now test endogeneity of the predictor variable based on the following regression model:
εt = α + γτt + ωt (2)
Where εt is the residual from Eq. (1) and τt is the residual from a first-order autoregressive model of the predictor variable. The results
from this regression model are reported in Table 2. We report the coefficient on γ, its t-statistic, and the probability value. We find
that for 12 out of the 16 currencies (75% of cases), γ is statistically significant. These 12 currencies are AUD, CAD, EUR, INR, MXN,
NZD, NOK, PEN, PLN, ZAR, KRW, and GBP. The implication here is that for these countries (the exceptions are JPY, PHP, SEK, and
THB) the forward premium is endogenous. Hence, while endogeneity of the forward premium is not an issue for all countries in our
sample, it does matter for a sizeable number of countries. Therefore, like persistency, the issue of endogeneity needs to be taken care
for in predictive regression models.
This now takes us to the final issue of relevance to predictive regression models—that being the heteroskedasticity of the returns
and forward premium. To investigate the presence or otherwise of heteroskedasticity, we begin with an analysis of autocorrelation.
Specifically, we estimate autocorrelations of squared returns and forward premiums at lags of six and 36. Table 3 contains the results.
For returns, we notice that for four currencies there is no evidence of autocorrelations at six lags; the autocorrelations are small and
statistically insignificant, in that the p-values are greater than 0.5. However, for the remaining 12 currencies strong evidence of
autocorrelations are found at both short and long lags. By comparison, in monthly data, the evidence of ARCH is extremely weak, as
demonstrated in the work of Baillie and Bollerslev (2000), and our results for daily spot returns seem consistent with those reported
in Baillie and Bollerslev (1989). When we consider autocorrelations in the forward premium, for all 16 countries the null hypothesis
5
Note that AUD, NZD, and GBP are indirect quotes against USD. Thus, when we discuss results, we read these currencies in the opposite direction
so that it is consistent with other currencies as they are direct quotes against USD.
6
Following Iyke (2019), we do an additional test. The Narayan and Popp (2010, 2013) structural break unit root test corroborates these findings.
4
Table 2
ADF and endogeneity test results.
Currency AR(1) ADF-test results Endogeneity
EX FWP-30 EX FWP-30 gamma t-stat p-value
Australian Dollar −0.017 0.121 −76.165[0] (0.000)*** −31.079[3] (0.000)*** −0.053 −4.006 0.000
Canadian Dollar 0.003 0.918 −74.647[0] (0.000)*** −4.447[9] (0.000)*** −0.887 −3.922 0.000
Euro 0.010 0.984 −70.594[0] (0.000)**** −2.087[5] (0.250) −2.073 −4.797 0.000
Indian Rupee 0.055 0.976 −69.516[0] (0.000)*** −5.999[3] (0.000)*** −0.586 −5.883 0.000
Japanese Yen 0.001 0.977 −74.809[0] (0.000)*** −1.923[9] (0.322) −0.109 −0.451 0.652
Mexican Peso 0.015 0.995 −73.754[0] (0.000) *** −3.375[3] (0.012)** 2.453 13.378 0.000
New Zealand Dollar −0.018 0.022 −76.247[0] (0.000) *** −7.525 [22] (0.000)*** 0.880 39.232 0.000
Norwegian Krone 0.004 0.888 −74.565[0] (0.000) *** −2.423[14] (0.136) −0.248 −1.994 0.046
Peruvian Sol 0.044 0.775 −58.332[0] (0.000) *** −3.154[15] (0.023)** 0.074 2.834 0.005
Philippine Piso 0.092 0.959 −40.623[3] (0.000) *** −4.945[8] (0.000)*** 0.024 0.290 0.772
Polish Zloty 0.026 0.990 −63.673[0] (0.000) *** −2.517[4] (0.112) −1.801 −3.331 0.001
S. African Rand 0.029 0.980 −72.718[0] (0.000) *** −2.754[12] (0.065)* 0.762 2.682 0.007
S. Korean Won 0.009 0.988 −64.761[0] (0.000) *** −3.512[30] (0.008)*** −4.834 −11.482 0.000
Swedish Krona −0.002 0.961 −75.040[0] (0.000) *** −2.065[8] (0.259) −0.457 −1.892 0.059
Thai Baht 0.110 0.924 −52.166[1] (0.000) *** −6.490[22] (0.000)*** −0.039 −0.846 0.397
UK Pound 0.023 0.163 −73.152[0] (0.000) *** −6.489[22] (0.000)*** −0.833 −32.608 0.000
This table reports a number of preliminary tests of the data. In columns 2 and 3, we report the autoregressive coefficient of the spot exchange rate
return (ER) and the forward premium (FWP-30), respectively. These coefficients are used to judge the degree of persistency. The ADF test, which
examines the null hypothesis of no unit root, is reported in columns 4 and 5. The null hypothesis of a unit root is tested for both variables. The
optimal lag length, chosen using the Schwarz Information Criterion, is reported in the square brackets. The optimal lag length is selected by starting
with a maximum of eight lags. The p-values, used to test the unit root null, are reported in parentheses. The last three columns report the en-
dogeneity test results. This test is based on regressing the error term from the predictive regression model on the error term from the predictor
variable; the coefficient, t-statistics, and p-value are reported. Finally, *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels
respectively.
Table 3
Autocorrelation results.
Currency EX FWP-30
6 lags 36 lags 6 lags 36 lags
AC p-value AC p-value AC p-value AC p-value
Australian Dollar −0.028 0.158 −0.009 0.000 0.065 0.000 0.043 0.000
Canadian Dollar −0.024 0.032 −0.018 0.000 0.907 0.000 0.847 0.000
Euro −0.008 0.807 −0.022 0.850 0.972 0.000 0.918 0.000
Indian Rupee −0.017 0.000 −0.028 0.000 0.908 0.000 0.740 0.000
Japanese Yen 0.002 0.866 0.019 0.056 0.971 0.000 0.946 0.000
Mexican Peso 0.024 0.000 −0.026 0.000 0.979 0.000 0.912 0.000
New Zealand Dollar −0.014 0.050 −0.007 0.166 0.119 0.000 0.103 0.000
Norwegian Krone −0.017 0.032 −0.016 0.170 0.881 0.000 0.847 0.000
Peruvian Sol 0.044 0.008 −0.032 0.000 0.323 0.000 0.270 0.000
Philippine Piso −0.001 0.000 0.015 0.000 0.920 0.000 0.816 0.000
Polish Zloty −0.025 0.010 −0.019 0.001 0.977 0.000 0.914 0.000
S. African Rand −0.021 0.005 0.005 0.038 0.963 0.000 0.906 0.000
S. Korean Won 0.028 0.002 −0.028 0.000 0.938 0.000 0.746 0.000
Swedish Krona −0.001 0.043 −0.006 0.008 0.953 0.000 0.920 0.000
Thai Baht −0.002 0.000 −0.047 0.000 0.736 0.000 0.434 0.000
UK Pound 0.018 0.087 −0.010 0.050 0.146 0.000 0.127 0.000
In this table, we report results from a test of autocorrelation. We square both variables and test for autocorrelation at lags of 6 and 36. We report the
resulting autocorrelation coefficient and its p-value used to test the null hypothesis of no autocorrelation.
of no autocorrelation is rejected strongly, suggesting that daily forward premiums are extremely heteroskedastic. Since the presence
of heteroskedasticity is the main issue considered in this paper from an econometric modelling point of view, we consider it im-
perative to conduct some additional tests on it. We, therefore, run an autoregressive model with 36 lags for returns and forward
premiums, and do a formal test of heteroskedasticity in each variable; see Table 4. We find much stronger evidence of ARCH. The null
hypothesis is rejected for the majority currencies in the case of forward premiums, while in the case of exchange rate returns the null
is rejected for all currencies (except NOK).
This then completes our preliminary analysis. We conclude that, for most countries, not only are persistency and endogeneity of
the predictor variable an issue, but so is heteroskedasticity. The only test that we are aware of that specifically models hetero-
skedasticity of variables in a predictive regression framework is Westerlund and Narayan (2012, 2015b). In fact, Westerlund and
5
Table 4
Heteroskedasticity test results.
Currency EX FWP-30
ARCH(6) ARCH(36) ARCH(6) ARCH(36)
Australian Dollar 200.86 (0.000)*** 46.74 (0.000)*** 155.88 (0.000)*** 41.31 (0.000)***
Canadian Dollar 90.18 (0.000)*** 39.44 (0.000)*** 1.99 (0.063)* 0.33 (1.000)
Euro 32.01 (0.000)*** 12.12 (0.000)*** 29.89 (0.000)*** 4.94 (0.000)**
Indian Rupee 142.12 (0.000)*** 31.31 (0.000)*** 70.50 (0.000)*** 14.59 (0.000)***
Japanese Yen 45.67 (0.000)*** 12.36 (0.000)*** 8.49 (0.000)*** 1.40 (0.056)*
Mexican Peso 231.37 (0.000)*** 41.26 (0.000)*** 165.67 (0.000)*** 37.85 (0.000)***
New Zealand Dollar 118.06 (0.000)*** 31.28 (0.000)*** 116.55 (0.000)*** 30.92 (0.000)***
Norwegian Krone 52.34 (0.000)*** 16.33 (0.000)*** 0.38 (0.891) 0.07 (1.000)
Peruvian Sol 40.97 (0.000)*** 10.28 (0.000)*** 81.53 (0.000)*** 17.37 (0.000)***
Philippine Piso 4.70 (0.000)*** 1.29 (0.112) 131.00 (0.000)*** 23.57 (0.000)***
Polish Zloty 139.17 (0.000)*** 30.30 (0.000)*** 50.60 (0.000)*** 8.37 (0.000)***
S. African Rand 123.64 (0.000)*** 25.25 (0.000)*** 84.70 (0.000)*** 33.15 (0.000)***
S. Korean Won 86.96 (0.000)*** 56.63 (0.000)*** 165.84 (0.000)*** 39.48 (0.000)***
Swedish Krona 65.30 (0.000)*** 29.56 (0.000)*** 3.46 (0.002)*** 0.57 (0.981)
Thai Baht 43.60 (0.000)*** 13.91 (0.000)*** 189.99 (0.000)*** 50.63 (0.000)***
UK Pound 34.51 (0.000)*** 8.18 (0.000)** 35.32 (0.000)*** 8.37 (0.000)***
In this table, we report results on heteroskedasticity of the exchange rate return and the forward premium variables. Essentially, we run an
autoregressive model for each variable with 36 lags and test for the null hypothesis of ‘no ARCH’ in the residuals of the model. The null is tested at
lags of six and 36. The LM test statistic is reported together with the p-value (in parentheses). Finally, *, **, and *** denote statistical significance at
the 10%, 5%, and 1% levels respectively.
Narayan (2012) show that, in the presence of heteroskedasticity, the Westerlund and Narayan (2012, 2015b) GLS-based test out-
performs the Lewellen (2004) and the OLS estimators.
3.2. In-sample predictability
We find relatively good evidence of predictability (Table 5). We find that the null hypothesis that forward premiums do not
predict changes in spot exchange rate is rejected only for six out of 16 currencies (i.e. 38% of the cases). The null cannot be accepted
for AUD, INR, NZD, PHP, THB, and GBP. When we consider forward premiums at different dates of maturity (i.e. 90-days, 180-days,
and 360-days), the results on predictability hold; however, we do note that the magnitude of predictability as denoted by the slope
coefficient declines as we move to a higher horizon of maturity. This, maybe, reflects the staleness of the information content. In the
stock market, similarly, it has been shown that stale news does predict returns (see Narayan, 2019).
In addition, we find that for four out of six currencies for which the null is rejected, forward premiums predict exchange rate
returns positively. These four currencies are AUD, INR, PHP, and THB. On the whole, our results are in line with those obtained by
Bansal and Dahlquist (2000), one of the very few studies based on developing/emerging countries. However, the BH study is based on
pooled regressions performed on different groups of countries while ours is a time-series analysis. BH, for a sample of low income,
high income, and emerging market countries, find a positive slope coefficient, while for a pooled regression based on a sample of
developed countries they find a negative slope coefficient. The negative slope found for developed countries is consistent with our
results for NZD and GBP.
3.3. Out-of-sample analysis
3.3.1. Statistical measures

In this section, following Narayan and Bannigidadmath (2015), Westerlund and Narayan (2015b) and the studies cited therein,
we consider some of the commonly used metrics, namely, the OOS R2 which we denote as OOS_R2, the Theil U statistic, and the
forecast encompassing statistic proposed by Clark and McCracken (2001), which we denote as ENC-NEW. Using these tests, we
compare the forecasting performance of our FPM relative to a RWM (our benchmark model). Following Westerlund and Narayan
(2012), we choose 50% of the sample period for each country and then use the estimates from this period to forecast exchange rate
returns recursively for the rest of the 50% of the sample. Therefore, our OOS period is 50% of the sample.7
The OOS_R2 is:
MSEmodel
OOS _R2 = 1 −
MSERW (3)
Here MSE is the mean squared error such that MSEmodel is the OOS predictions from our proposed model, while MSERW is the error
from the RWM. When OOS_R2 > 0, our model beats the RWM, and vice versa. By comparison, the Theil U < 1 our model beats the
7
For an excellent OOS evaluation of spot and forward rates can be found in Chiang (1988).
6
Table 5
Predictability test results.
Panel A: In-sample predictability results
Currency 30-day 90-day 180-day 360-day
Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
Australian Dollar 0.823*** 0.000 0.399*** 0.000 0.127*** 0.000 0.026*** 0.000
Canadian Dollar −0.041 0.523 −0.017 0.451 −0.010 0.369 −0.007 0.249
Euro −0.047 0.483 −0.023 0.326 −0.010 0.377 −0.005 0.411
Indian Rupee 0.103*** 0.000 0.045*** 0.000 0.019*** 0.000 0.004*** 0.000
Japanese Yen 0.000 0.995 −0.001 0.937 −0.001 0.888 −0.001 0.722
Mexican Peso −0.015 0.298 −0.003 0.508 −0.001 0.590 0.000 0.917
New Zealand Dollar −0.710*** 0.000 −0.286*** 0.000 −0.105*** 0.000 −0.038*** 0.000
Norwegian Krone −0.052 0.304 −0.024 0.176 −0.014 0.122 −0.009* 0.066
Peruvian Sol 0.000 0.917 0.000 0.880 0.000 0.139 0.000 0.232
Philippine Piso 0.291*** 0.000 0.038*** 0.000 0.019*** 0.000 −0.010*** 0.000
Polish Zloty −0.013 0.780 −0.010 0.549 −0.008 0.358 −0.005 0.263
S. African Rand −0.014 0.681 −0.013 0.331 −0.008 0.297 −0.003 0.408
S. Korean Won −0.060 0.234 −0.024 0.162 −0.014 0.127 −0.007 0.147
Swedish Krona −0.076 0.185 −0.032 0.104 −0.018* 0.080 −0.010* 0.054
Thai Baht 0.066*** 0.000 0.025*** 0.000 0.010** 0.015 0.005** 0.024
UK Pound −0.725*** 0.000 −0.257*** 0.000 −0.088*** 0.000 −0.031*** 0.000
Panel B: Out-of-sample evaluations

Currency Out of sample size Theil U OOS_R2 ENC_NEW
Australian Dollar 2804 0.9914 0.0172 65.95***
Canadian Dollar 2804 0.9998 0.0003 1.09
Euro 2544 1.0001 −0.0002 0.46
Indian Rupee 2698 1.0020 −0.0039 2.29**
Japanese Yen 2804 0.9996 0.0008 1.39
Mexican Peso 2804 0.9985 0.0030 5.12***
New Zealand Dollar 2804 1.0943 −0.1974 −25.20***
Norwegian Krone 2804 0.9990 0.0019 3.58***
Peruvian Sol 1860 0.9998 0.0004 2.20**
Philippine Piso 2804 1.0007 −0.0015 23.67***
Polish Zloty 2138 0.9976 0.0048 7.74***
S. African Rand 2804 0.9998 0.0003 1.86*
S. Korean Won 2138 0.9994 0.0011 1.50
Swedish Krona 2804 0.9996 0.0009 2.30**
Thai Baht 2804 0.9993 0.0013 19.93***
UK Pound 2804 1.0533 −0.1094 18.84***
In this table, we report the results from the time-series predictive regression model proposed by WN (2012, 2015) in Panel A. The regression model
regresses the exchange rate returns on the one-period lagged forward premium variable. The null hypothesis is that the forward premium does not
predict exchange rate returns. The predictor variable, forward premium, is proxied by 30-day, 90-day, 180-day, and 360-day premiums. For each
country's predictive regression model we report the coefficient on the one-period lagged premium (predictor) variable and its p-value. Additionally,
we report out-of-sample evaluations in Panel B. We set the out-of-sample period equivalent to 50% of the sample size. In columns 3–5 we report
three of the commonly-used metrics, namely, the Theil U statistic, the out-of-sample R2, which we denote as OOS_R2, and the forecast encompassing
statistic proposed by Clark and McCracken (2001), which we denote as ENC_NEW, which has a standard normal distribution and we consider 1.64
(1.96) 2.57 as the critical values at the 10% (5%) 1% levels. These tests are used as measures of the out-of-sample forecasting performance of our
FPM relative to a RWM, which is typically used in the return predictability literature as a benchmark model. Finally, *, **, and *** denote statistical
significance at the 10%, 5%, and 1% levels respectively.
RWM.
Lastly, the ENC-NEW is as follows:
T
(T − T0)−1 ∑t = T0 
μ0, t + 1 (
μ0, t + 1 − 
μ1, t + 1 )
ENC − NEW = (T − T0) T
(T − T0)−1 ∑t = T0 
μ1,2t + 1 (4)
where t0 to T0 denotes in-sample period and we forecast the returns for the period T0 + 1. Here T0 is the number of in-sample
observations. The ENC-NEW test evaluates whether our model provides useful information for predicting spot exchange return vis-à-
vis the RWM.
The total number of observations in the out-of-sample analysis for each country is reported in column 2 (see Table 5). The ratio of
the Theil U statistic is reported in column 3. We find that the ratio is less than 1 for AUD, CAD, JPY, MXN, NOK, PEN, PLN, ZAR,
KRW, SEK, and THB. This suggests that in 69% of the cases (11 out of 16 currencies), the proposed predictive regression model
outperforms the RWM. This result is corroborated by the OOS_R2, which is positive for those 11 countries and negative for the other
five currencies (namely, EUR, INR, NZD, PHP, and GBP). The ENC-NEW statistic, meanwhile, suggests a positive sign and is
7
statistically significant for 11 out of 16 countries (69% of cases). Considering both in-sample and OOS evidence of predictability, we
see: (a) that for those six currencies (AUD, INR, NZD, PHP, THB, and GBP) that were predictable in-sample are also predictable OOS
(except NZD); (b) OOS tests reveal predictability for an additional six currencies (MXN, NOK, PEN, PLN, ZAR, and SEK) which were
not predictable in-sample. Overall, therefore, 75% of the currencies in our sample are predictable; and (c) in the case of four
currencies (CAD, JPY, EUR, and KRW) the evidence of predictability is almost indefinite.
When both in-sample and out-of-sample evidence are considered, four currencies (CAD, EURO, JPY, and KRW) turn out to be
unpredictable. This absence of predictability tends to imply that price adjustments to new information is instantaneous for these
currencies. It may also be a case that for these currencies predictability maybe present in a time-varying fashion, similar to what has
been discovered in stock returns (see Devpura et al., 2018) and commodity returns (Narayan and Sharma, 2018). In the exchange rate
market, this type of exchange rate behaviour has been discovered by Charles et al. (2012), consistent with the adaptive market
hypothesis. The time-varying relation may be a result of exchange rate bubbles, financial cycles, crashes, amongst others. This
requires more research, particularly an extension of our model to a time-varying model—an issue beyond the scope of the present
paper and therefore left for future research.
The last message from our statistical results is the evidence of predictability between developed and developing country cur-
rencies. When we consider in-sample evidence, the evidence of predictability is the same: 3 currencies each fo developed and
developing countries are predictability. However, when we consider out-of-sample evidence then 7/8 (5/8) developing (developed)
country currencies are predictability. This suggests that predictability is greater in the case of developing countries. Why precisely
this happens is unclear but drawing purely on the theory we hypothesize that prices in developing countries take time to reflect all
new information due to perhaps greater information asymmetry and the existence of a larger informal sector financial market. This
hypothesis though remains to be tested and will be ideal for future research.
3.3.2. Trading strategy-based profits

What is the economics behind the statistics in the preceding section? When it comes to forecasting, an investor's concern is always
about how much better off he/she is from paying attention to the forecasts from the predictive regression model, where the predictor
variable is forward premium as opposed to simply using a RWM to generate forecasts of exchange rate changes. This is a question of
the economic significance of forward premium as a predictor of changes in exchange rate. The intuition is simple. If by following
forecasts from the FPM, an investor can make more profits compared to a RWM, then one can claim that the FPM is relatively better
than a RWM. Before we begin to consider profits from the two models, it is imperative to highlight a relevant issue from the literature
on the economic significance of predictor variables, particularly in predicting stock returns. First, typically in this literature, on the
assumption of a mean-variance investor, investor utility or certainty equivalent return has been computed. This framework requires
an investor to obtain portfolio weights, the sum of which equates to unity, that are then assigned to risky and risk-free assets.
Typically, in this literature, excess returns rather than returns are predicted. In our model of predictability, we have changes in
exchange rates and a risk-free asset is not part of the model at the outset. While this can be introduced, it is not the point of the paper.
We specifically test a hypothesis for which limited success has been documented. Therefore, rather than taking issue with investor
utility, we focus on investor profits. In this regard, it is not uncommon in the exchange rate literature to test for profitability of
exchange rates (see LeBaron, 1999; Dueker and Neely, 2007). In fact, there is considerable literature on this, and our motivation is,
indeed, derived from this literature.
Our exchange rate trading strategy is as follows. We generate trading signals on the basis of exchange rate forecasts from a RWM
and from the FPM. Based on these trading signals, we undertake buy and sell decisions. Our trading strategy can be summarised as
follows: an investor takes a long position whenever  ERt + 1 > 0 and a short position whenever ERt + 1 ≤ 0 , where 
ERt + 1 is the predicted
exchange rate. This trading strategy is motivated by the work of Anatolyen and Gerko (2005), who use the same exchange rate
trading strategy to extract buy and sell signals. We follow Szakmary and Mathur (1997) and compute profits (π) as follows:
πt = Longt ∗ ERt + (Longt − 1) ∗ ERt − |Longt − Longt − 1 | ∗ ct (5)
where Longt = 1 whenever there is a buy signal, and Longt = 0 whenever there is a sell signal. Whenever a new position is
Ask − Bid
established, a transaction cost ct = Askt + Bidt is allowed for, as shown by the last term on the right-hand side of the equation. Askt and
t t
Bidtare the spot ask and bid prices of a currency.
The Anatolyen and Gerko (2005) proposal is used because it allows us to use their trading strategy to test the null hypothesis of no
mean predictability. Their proposal makes use of profits obtained from the OOS trading strategy, and has the following form:
πFP − πRW / CT
EP =
varFP − varRW / CT (6)
Here, πFP and πRW/πCT denotes profits from the FPM and RWM, respectively; and varFP and varRW/varCT are the variances of πFP
and πRW/πCT, respectively. Profits are averaged over time. Variance of profits becomes:
T−1
var (πFP − πRW / CT ) = 4 p  (1 − p 
ER ) var (ERt )
T 2 ER (7)
ER is the probability that the return forecast has a non-negative sign, and var(ERt)
Here, T is the sample size (out-of-sample), p 
represents the variance of the actual exchange rate return series.
Our results are summarised in Table 6. Column 2 reports profits and standard deviation from the benchmark RWM, while the
corresponding results from the FPM are reported in column 3. Additionally, we also compute the foreign exchange CTM returns so
8
Table 6
Results on profits.
Currency RWM FPM CTM EP Test
Mean SD Mean SD Mean SD FPM vs RWM FPM vs CTM
Australian Dollar −0.0230 0.8446 0.3782 0.7482 −0.0047 1.1062 29.6936*** 28.3369***
Canadian Dollar −0.0241 0.6447 −0.0005 0.6449 −0.0319 0.5080 2.0271** 2.6912***
Euro −0.0144 0.6326 −0.0088 0.6326 −0.0216 0.3740 0.5223 1.2026
Indian Rupee 0.0177 0.4655 −0.0018 0.4661 −0.0043 0.6355 −2.8077*** 0.3726
Japanese Yen −0.0194 0.6737 0.0000 0.6740 −0.0366 0.6425 1.7165* 3.2391***
Mexican Peso 0.0135 0.7840 0.0240 0.7836 −0.0174 1.5679 2.4141** 9.5171***
New Zealand Dollar 0.0476 0.8742 −0.0190 0.8737 0.0653 1.2683 −4.7785*** −6.0483***
Norwegian Krone −0.0206 0.8336 −0.0152 0.8330 −0.0504 1.2242 0.4544 2.9793***
Peruvian Sol −0.0096 0.3325 −0.0008 0.3320 −0.0218 0.3647 1.4549 3.4565***
Philippine Piso 0.0003 0.3353 −0.0176 0.3345 −0.0248 0.3467 −3.1481*** 1.2530
Polish Zloty −0.0314 0.9572 −0.0300 0.9564 −0.0378 0.5872 0.0767 0.4451
S. African Rand 0.0192 1.0834 0.0304 1.0836 −0.0594 2.1670 1.2032 9.6759***
S. Korean Won −0.0229 0.5483 −0.0040 0.5481 −0.0077 0.5318 1.6781* 0.3306
Swedish Krona −0.0123 0.8115 −0.0058 0.8114 −0.0283 0.7888 0.5562 1.9158*
Thai Baht −0.0142 0.2853 −0.0036 0.2837 −0.0243 0.5636 3.3684*** 6.5810***
UK Pound −0.0090 0.6295 0.0095 0.6299 0.0070 0.8987 1.6950* 0.2223
In this table, we report daily profits (%) from our trading strategies. We generate trading signals on the basis of exchange rate forecasts from a RWM
and from the FPM. Based on these trading signals, we undertake buy and sell decisions. Our trading strategy is as follows: an investor takes a long
position whenever  ERt + 1 > 0 , and a short position whenever 
ERt + 1 ≤ 0 , where 
ERt + 1 is the predicted exchange rate. This trading rule is applied to
forecasts from the FPM and from a RWM. We also implement a CTM strategy. We consider a transaction cost of one-half of the currency bid–ask
spread. The daily profits (%) and standard deviation are reported. We also report the EP test which, essentially, examines the null hypothesis of no
mean predictability of profits from FPM over the profits from RWM or CTM. Finally, *, **, and *** denote statistical significance at the 10%, 5%, and
1% levels respectively.
that it can be compared with our proposed trading strategies.8 The results on foreign exchange CTM returns are reported in column 3.
In the final column, we report the EP test statistic. Regarding profits from our simple trading strategy, we observe the following. First,
the FPM-based forecasts lead to either profit maximisation or loss minimisation compared to profits from a RWM. In other words,
profits from the RWM are negative for 11 countries (69% of cases), except in the case of five currencies (namely INR, MXN, NZD,
PHP, and ZAR) where we observe positive profits. When we draw forecasts from the FPM, we find positive returns only in 31% of
cases (AUD, JPY, MXN, ZAR, and the GBP). It is worth highlighting that where returns are negative from the FPM, they are smaller
than negative returns from the RWM. These results suggest that investors investing in all 16 currencies are better off by devising buy
and sell signals from the FPM.
Next, we have noted that the CTM returns are reported negative in 88% of currencies considered in our study. The exceptions are
only for two currencies, NZD and the GBP, where carry trade returns are found to be positive. In fact, once again our FPM provides
much better returns compared to the CTM returns. We conclude this because where returns are negative from the CTM approach,
they are larger than negative returns from our proposed FPM.
Second, previously we reported that based on the statistical measures of out-of-sample performance, the Theil U and the OOS_R2
favoured the FPM over the RWM for 11 countries. From the trading strategy-based profits, we notice that for four of these 11
currencies (AUD, JPY, MXN, and ZAR) returns are positive.
Finally, we consider the test results reported in the last column of Table 6. Here, our EP test results are reported based on two
comparisons. First, we compare our proposed FPM-based profits with the RWM-based profits, and second, we compare FPM based
returns with the CTM returns. Two results are worth highlighting here. First, for 9 of the 10 countries, the null of no mean pre-
dictability is rejected, suggesting that the FPM generates better out-of-sample forecasting performance based on our trading strategy.
It follows that a trading strategy based out-of-sample forecasting performance provides greater evidence in support of a FPM over a
RWM and as well as foreign exchange CTM strategy. Second, of the 11 countries for which purely statistical measures had suggested
that a FPM is superior to a RWM, the EP test corroborates this finding.
3.3.3. Robustness test

So far, our empirical analysis is based on a sample period that includes the global financial crisis. It is possible that our results
reported in previous sections could be affected by the global financial crisis. To check whether this is the case, we re-estimate all
results over the pre-crisis period; that is, we include data only up to 9/14/2008. We only report here the results on predictability (see
Table 7); the rest of the results, such as those relating to persistency, endogeneity, and heteroskedasticity, are not reported here
simply because they are similar to the ones reported for the entire sample size. The main features of the data remain the same.
Reading the results from the in-sample predictability test (see Panel A), we find that the null is rejected in 44% of currencies
8
In the carry trade strategy, investors borrow in the lower interest currency and lend in the higher interest rate currency. We apply the carry trade
strategy for each currency against the USD.
9
Table 7
Robustness test on predictability.
Panel A: In-sample predictability test results
Currency Coefficient p-value
Australian Dollar 0.8399*** 0.0000

Canadian Dollar −0.1106 0.1235
Euro −0.0977 0.2288
Indian Rupee 0.1528*** 0.0000
Japanese Yen −0.0755 0.3304
Mexican Peso −0.0193 0.1726
New Zealand Dollar −0.6636*** 0.0000
Norwegian Krone −0.0741 0.1675
Peruvian Sol −0.0013 0.7181
Philippine Piso 0.4129*** 0.0000
Polish Zloty 0.0124 0.8243
S. African Rand 0.0031 0.9311
S. Korean Won −0.0556 0.3412
Swedish Krona −0.1207* 0.0822
Thai Baht 0.0548*** 0.0063
UK Pound −0.7509*** 0.0000
Panel B: Out-of-sample evaluations.

Australian Dollar 1527 0.9521 0.0935 101.8361
Canadian Dollar 1527 1.0000 0.0000 1.0181
Euro 1266 1.0017 −0.0034 −0.5141
Indian Rupee 1420 1.0025 −0.0049 2.6067
Japanese Yen 1527 0.9989 0.0021 2.4508
Mexican Peso 1527 0.9999 0.0002 1.9400
New Zealand Dollar 1527 1.0624 −0.1288 5.5853
Norwegian Krone 1527 1.0028 −0.0057 −1.8702
Peruvian Sol 583 1.0000 0.0000 0.7551
Philippine Piso 1527 0.9887 0.0224 37.4007
Polish Zloty 860 1.0048 −0.0096 −1.9380
S. African Rand 1527 1.0003 −0.0006 0.4697
S. Korean Won 860 0.9995 0.0010 0.8114
Swedish Krona 1527 1.0015 −0.0030 1.5665
Thai Baht 1527 0.9819 0.0359 43.5486
UK Pound 1527 1.0597 −0.1229 3.9407
In this table, we report in-sample (see Panel A) and out-of-sample (see Panel B) predictability test results for pre-crisis period. Refer Table 5 for detail
notes. Finally, *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels respectively.
considered in the study: for SEK at the 10% level and for AUD, INR, NZD, PHP, THB, and GBP at the 1% level. Consistent with
previous results, forward premium positively predicts exchange rate returns for four currencies (namely AUD, INR, PHP, and THB).
In Panel B of Table 7, we report the out-of-sample predictability results. Based on the Theil U statistic, the Theil U < 1 in 38% of
cases, suggesting that the FPM outperforms the RWM for only six countries (namely, AUD, JPY, MXN, PHP, KRW, and THB). The
OOS_R2 and the ENC-NEW provide relatively stronger evidence in favour of the FPM over the RWM.
Finally, we estimate profits from our simple strategy as before for all countries and report the results together with the standard
deviation of profits and the EP test in Table 8. As with previous results, we find that the FPM-based forecasts lead to either profit
maximisation or loss minimisation compared to profits from a RWM. In other words, profits from the RWM are negative for all
currencies (except in the case of NOK), while five countries have positive returns when using forecasts drawn from the FPM. Ad-
ditionally, foreign exchange CTM profits are reported negative for all currencies, except in the cases of EUR and NZD. Like before,
sign matters for profitability. Of the two countries for which forward premium negatively predicted returns, both had positive profits
while of the four countries where predictability appeared with a positive sign, for only Thailand profits were negative. The results of
the EP test suggest that the null of no mean predictability is rejected for 10 countries when we compare RWM profits with FPM-based
profits, and in eight countries when FPM-based returns are compared with CTM returns. This means that the FPM generates better
out-of-sample forecasting performance based on our trading strategy. On the whole, from our empirical analysis over the pre-global
financial crisis period, we conclude that the results are unchanged. The main findings that the FPM consistently beats the RWM in
out-of-sample evaluations, hold.
4. Additional results
While our main results are based on a floating rate regime because predictability analysis makes more sense to examine floating
regimes, we also do an analysis of exchange rate currencies (such as the Swiss franc, the Norwegian Krone, the Danish Krone) which
follow different regimes. We have used Exchange Arrangements and Exchange Restrictions IMF 1997–2017 annual reports to collect
10
Table 8
Robustness test - Results on profits.
Australian Dollar −0.0194 0.6995 0.3467 0.5993 −0.0390 0.9142 26.4034*** 27.8158***
Canadian Dollar −0.0088 0.5517 0.0003 0.5518 −0.0133 0.2967 0.6752 1.0129
Euro −0.0186 0.5366 0.0046 0.5367 0.0095 0.2170 1.6981* −0.3572
Indian Rupee −0.0138 0.2894 0.0056 0.2870 −0.0291 0.4950 4.9242*** 8.8388***
Japanese Yen −0.0137 0.5924 −0.0069 0.5923 −0.0149 0.8369 0.5411 0.6310
Mexican Peso −0.0085 0.4549 0.0035 0.4546 −0.0109 0.9095 2.6089** 3.1281***
New Zealand Dollar −0.0145 0.7568 0.0097 0.7572 0.0617 1.2114 1.4906 −3.1852***
Norwegian Krone 0.0232 0.6636 −0.0181 0.6647 −0.0211 0.7058 −3.0797*** 0.2225
Peruvian Sol −0.0177 0.3577 0.0159 0.3553 −0.0223 0.0919 2.2939** 2.6115***
Philippine Piso −0.0203 0.3183 0.0087 0.3155 −0.0743 0.4247 4.5625*** 13.0383***
Polish Zloty 0.0337 0.6754 −0.0182 0.6761 −0.0415 0.8810 −2.3131** 1.0400
S. African Rand −0.0313 1.0554 −0.0153 1.0552 −0.0657 2.0999 1.2690 3.9972***
S. Korean Won −0.0209 0.4899 −0.0272 0.4895 −0.0503 0.3711 −0.3135 1.1413
Swedish Krona −0.0143 0.5877 −0.0275 0.5867 −0.0564 0.1219 −0.6640 1.4585
Thai Baht −0.0248 0.4523 −0.0135 0.4499 −0.0268 0.8991 1.9211* 2.2614**
UK Pound −0.0133 0.5170 0.0073 0.5173 −0.0050 0.8278 2.0441** 1.2237
In this table, we report daily profits (%) from our trading strategies considered over pre-crisis period. See Table 6 for detail notes. Finally, *, **, and
*** denote statistical significance at the 10%, 5%, and 1% levels respectively.
detail information on exchange rate regimes adopted by other 34 countries. The list of these 34 countries and their respective
currency regimes adopted during each year over the period 1997–2017 are given in an online Appendix Table A. The reason we had
not included these currencies in our main analysis was because these currencies are characterized by different exchange rate regimes
over the sample period, thus making a test of predictability difficult. We, therefore, warn that readers exercise caution in interpreting
these results. The results are more for information than policy.
Our approach in conducting the predictability analysis of these 34 currencies remain same. Overall, our findings remain same
regarding the three salient features of predictor variables. We find forward premium is highly persistent and endogenous.
Additionally, we have comfortably rejected the null of “no ARCH” in almost all 34 forward premium series. These results are not
tabulated here but are available upon request.
Our predictability test results for these additional 34 countries are reported in Table 9. First, we will discuss Westerlund and
Narayan (2012, 2015b) in-sample predictability test results from Panel A. We have rejected the null hypothesis of “no predictability”
in 53% of cases. Currencies for which we have found forward premium as a significant predictor of exchange rate returns include
ARS, CLP, CNY, CZK, EGP, HKD, IDR, KZT, MYR, OMR, PKR, QAR, RUB, SAR, CHF, TND, TRY, and the UED. We find that in 50% of
these 18 countries (namely, ARS, CLP, CNY, CZK, KZT, MYR, OMR, RUB, and TND), forward premium positively predicts exchange
rate returns, and in the remaining 50%, the sign of predictability is negative.
We now consider out-of-sample evaluations and report these results in Panel B of Table 9. The ratio of the Theil U statistics is less
than one in 56% of the 34 countries. For the same 56% of the countries, we also report positive OOS_R2. In other words, our results
imply that for 19 out of 34 currencies (namely ARS, BGN, CNY, HRK, CZK, HKD, HUF, ILS, KZT, LVL, LTL, MYR, MTL, MAD, QAR,
RUB, SAR, CHF, and TRY), our proposed FPM outperforms the benchmark RWM. Additionally, Clark and McCracken ENC-NEW
statistic, meanwhile, suggests a positive sign and is statistically significant for all currencies, favouring the predictive regression
model, except in the case of COP, DKK, ISK, PKR, and TND.
Next, we report daily profits from our trading strategies in Table 10. Overall, we find profits from FPM are positive in 53% of cases
(18/34 countries), whereas profits from RWM are positive only in 38% of cases. For the remaining countries where profits are
reported negative, the FPM-based return values are smaller compared to returns obtained from RWM. The same observation is made
when CTM returns are compared with our proposed FPM-based returns. Overall, we find that investors are better off in using FPM-
based predictability model while constructing trading strategies for profitability. Additionally, the null of “no mean predictability” is
rejected in more than 55% of cases, suggesting that the FPM generates better out-of-sample forecasting performance based on our
trading strategy. It follows that a trading strategy based out-of-sample forecasting performance provides greater evidence in support
of a FPM over a RWM and as well as foreign exchange CTM strategy.
As mentioned earlier, the sample period considered in our paper includes GFC period. Thus, for robustness check of our results,
we have conducted the same analysis using data over pre-crisis period. The predictability test results during pre-crisis period are
reported in Table 11. The in-sample predictability test results (see Panel A) are almost consistent with what we have discussed earlier.
There are only three exceptions: (1) For two currencies, QAR and SAR, the predictability sign changed from negative to positive when
we consider data over pre-crisis period compared to results for full-sample period; (2) For seven currencies (namely ARS, EGP, KAT,
MYR, CHF, TND, and the AED), predictability of exchange rate returns become insignificant during pre-crises period whereas it was
statistically significant over full sample period; and (3) We find forward premium significantly and positively predicts exchange rate
returns of Colombia and Jordan only during pre-crisis period.
Moreover, the out-of-sample evaluations during the pre-crisis period are reported in Panel B of Table 11. Again, our out-of-sample
11
Table 9
Predictability test results for other currencies.
Argentine Peso (ARS) 0.005*** 0.000 0.022*** 0.000 0.003*** 0.000 0.000 0.383
Bulgarian Lev (BGN) 0.033 0.611 0.010 0.602 0.004 0.680 0.001 0.803
Chilean Peso (CLP) 0.106** 0.029 0.033* 0.060 0.017* 0.071 0.009* 0.071
Chinese Yuan Renminbi (CNY) 0.098* 0.000 0.033*** 0.000 0.019*** 0.000 0.009*** 0.000
Colombian Peso (COP) 0.055 0.102 0.000 0.989 −0.009 0.307 −0.007 0.120
Croatian Kuna (HRK) −0.011 0.827 0.000 0.981 0.002 0.790 0.001 0.763
Czech Koruna (CZK) 0.049*** 0.075 0.014 0.140 0.006 0.288 0.002 0.509
Danish Krone (DKK) −0.065 0.305 −0.029 0.186 −0.016 0.144 −0.009* 0.097
Egyptian Pound (EGP) −0.106*** 0.000 −0.037*** 0.000 0.007*** 0.000 0.007*** 0.000
Hong Kong Dollar (HKD) −0.063*** 0.000 −0.004*** 0.000 −0.002*** 0.000 0.000*** 0.000
Hungarian Forint (HUF) 0.010 0.666 0.003 0.716 0.001 0.737 0.000 0.866
Icelandic Krona (ISK) −0.026 0.692 −0.014 0.544 −0.007 0.575 −0.006 0.349
Indonesian Rupiah (IDR) −0.021*** 0.000 −0.022*** 0.000 −0.001** 0.020 −0.001 0.336
Israeli Sheqel (ILS) −0.013 0.816 −0.009 0.636 −0.006 0.543 −0.004 0.432
Jordanian Dinar (JOD) 0.001 0.906 −0.002 0.341 −0.001 0.632 −0.001 0.325
Kazakh Tenge (KZT) 0.090*** 0.000 0.035*** 0.000 −0.001 0.448 0.001 0.132
Kenyan Shilling (KES) −0.010 0.354 −0.005 0.143 −0.002 0.196 −0.001 0.221
Kuwaiti Dinar (KWD) 0.021 0.182 0.009 0.108 0.006** 0.031 0.004 0.012
Latvian Lat (LVL) −0.067 0.204 −0.018 0.169 −0.008 0.181 −0.004 0.173
Lithuanian Lita (LTL) 0.046 0.541 0.001 0.944 0.000 0.971 −0.001 0.875
Malaysian Ringgit (MYR) 0.056* 0.099 0.017 0.166 0.008 0.199 0.008* 0.090
Maltese Lira (MTL) −0.055 0.508 −0.019 0.508 −0.008 0.565 −0.004 0.588
Moroccan Dirham (MAD) 0.018 0.552 0.008 0.431 0.005 0.422 0.003 0.343
Omani Rial (OMR) 0.005*** 0.002 0.002*** 0.000 0.001** 0.023 0.000*** 0.006
Pakistani Rupee (PKR) −0.024*** 0.006 −0.011*** 0.000 −0.008*** 0.000 −0.017*** 0.000
Qatari Riyal (QAR) −0.007*** 0.000 −0.001* 0.088 0.000 0.764 0.000 0.885
Romanian Leu (RON) 0.000 0.997 0.001 0.882 0.001 0.895 0.001 0.804
Russian Fed. Ruble (RUB) 0.062*** 0.000 0.020*** 0.000 0.010*** 0.000 0.005*** 0.000
Saudi Arabian Riyal (SAR) −0.029*** 0.000 −0.012*** 0.000 −0.006*** 0.000 −0.002*** 0.000
Singaporean Dollar (SGD) −0.019 0.560 −0.008 0.495 −0.005 0.443 −0.002 0.453
Swiss Franc (CHF) −0.149** 0.014 −0.057*** 0.008 −0.031*** 0.007 −0.017*** 0.008
Tunisian Dinar (TND) 0.053*** 0.007 0.022*** 0.003 0.012*** 0.004 0.005*** 0.003
Turkish Lira (TRY) −0.051*** 0.000 0.021*** 0.000 0.005*** 0.000 0.002*** 0.000
UAE Dirham (AED) −0.004* 0.064 −0.001 0.293 −0.004*** 0.000 0.000 0.426
Panel B: Out-of-sample evaluations

Argentine Peso (ARS) 1860 0.9613 0.0760 124.1451
Bulgarian Lev (BGN) 1860 0.9991 0.0018 1.9784
Chilean Peso (CLP) 1860 1.0015 −0.0030 1.1071
Chinese Yuan Renminbi (CNY) 2138 0.9981 0.0038 7.9413
Colombian Peso (COP) 1860 1.0050 −0.0099 −4.4624
Croatian Kuna (HRK) 1860 0.9993 0.0013 1.3991
Czech Koruna (CZK) 2804 0.9995 0.0011 4.0464
Danish Krone (DKK) 2804 1.0005 −0.0010 −0.2447
Egyptian Pound (EGP) 1860 1.0051 −0.0103 1.5260
Hong Kong Dollar (HKD) 2804 0.9954 0.0093 18.5832
Hungarian Forint (HUF) 2698 0.9995 0.0010 4.4659
Icelandic Krona (ISK) 1860 1.0005 −0.0010 −0.0599
Indonesian Rupiah (IDR) 2804 1.0036 −0.0072 14.1414
Israeli Sheqel (ILS) 1860 0.9999 0.0002 2.5521
Jordanian Dinar (JOD) 1860 1.0718 −0.1487 56.4641
Kazakh Tenge (KZT) 1860 0.9756 0.0482 68.5763
Kenyan Shilling (KES) 1860 1.1714 −0.3722 39.8663
Kuwaiti Dinar (KWD) 2804 1.0144 −0.0289 7.7263
Latvian Lat (LVL) 1860 0.9993 0.0014 1.8670
Lithuanian Lita (LTL) 1860 0.9991 0.0017 1.8470
Malaysian Ringgit (MYR) 1589 0.9990 0.0020 1.8719
Maltese Lira (MTL) 1860 0.9995 0.0010 1.4935
Moroccan Dirham (MAD) 1860 0.9993 0.0014 1.4309
Omani Rial (OMR) 1860 1.0735 −0.1524 48.9274
Pakistani Rupee (PKR) 1860 1.0033 −0.0065 −1.3931
Qatari Riyal (QAR) 1860 0.9514 0.0949 139.4724
Romanian Leu (RON) 1860 1.0000 −0.0001 0.0623
Russian Fed. Ruble (RUB) 1860 0.9840 0.0317 43.4853
(continued on next page)
12
Table 9 (continued)
Saudi Arabian Riyal (SAR) 2804 0.9943 0.0115 30.4139

Singaporean Dollar (SGD) 2804 1.0007 −0.0014 0.2526
Swiss Franc (CHF) 2804 0.9993 0.0015 3.0453
Tunisian Dinar (TND) 1860 1.0037 −0.0074 −5.2413
Turkish Lira (TRY) 2804 0.9992 0.0016 20.4055
UAE Dirham (AED) 2804 1.0819 −0.1704 128.3899
In this table, we report in-sample (see Panel A) and out-of-sample (see Panel B) predictability test results for additional 34 currencies. Refer Table 5
for detail notes. Finally, *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels respectively.
Table 10
Profits for other currencies.
Argentine Peso 0.1054 1.1391 0.1106 1.1383 −0.0621 2.2802 1.6498* 54.4848***
Bulgarian Lev −0.0191 0.5564 −0.0139 0.5565 −0.0284 0.6671 0.4679 1.3172
Chilean Peso 0.0097 0.5811 0.0192 0.5807 −0.0422 1.0757 0.9355 6.0331***
Chinese Yuan Renminbi 0.0030 0.1531 −0.0053 0.1530 0.0172 0.1719 −2.5718*** −6.9265***
Colombian Peso 0.0394 0.7298 −0.0187 0.7323 −0.0425 0.9943 −4.0481*** 1.6632*
Croatian Kuna −0.0445 0.5757 0.0019 0.5761 −0.0595 0.9272 4.7835*** 6.3334***
Czech Koruna −0.0333 0.8083 −0.0099 0.8078 −0.0818 0.6224 1.5720 4.8343***
Danish Krone −0.0180 0.6313 −0.0043 0.6314 −0.0235 0.4342 1.4317 2.0032**
Egyptian Pound 0.0378 1.4264 0.0553 1.4267 −0.1127 2.9229 0.9199 8.8596***
Hong Kong Dollar −0.0027 0.0323 0.0003 0.0323 −0.0010 0.0417 7.4522*** 3.1271***
Hungarian Forint −0.0129 0.9912 0.0143 0.9900 −0.0728 1.8291 2.3551** 7.5345***
Icelandic Krona −0.0064 0.5719 −0.0026 0.5714 −0.1008 1.1428 2.9480*** 77.6627***
Indonesian Rupiah 0.0165 0.4550 0.0170 0.4501 −0.0469 0.9099 0.2038 23.6611***
Israeli Sheqel 0.0006 0.4318 −0.0070 0.4310 −0.0334 0.5795 −0.7927 2.7272***
Jordanian Dinar −0.0355 0.0946 −0.0162 0.0821 −0.0686 0.0933 16.8892*** 45.8644***
Kazakh Tenge 0.0384 0.9600 0.0467 0.9565 −0.0768 1.9141 0.7584 11.2097***
Kenyan Shilling 0.0010 0.3378 0.0076 0.3336 NA NA 1.2118 NA
Kuwaiti Dinar −0.0539 0.2137 0.0013 0.1959 −0.1197 0.2764 16.6454*** 36.4915***
Latvian Lat −0.0466 0.5566 0.0119 0.5553 −0.0595 0.9273 9.7113*** 11.8603***
Lithuanian Lita −0.0271 0.5567 −0.0074 0.5569 −0.0329 0.7165 1.7998* 2.3269**
Malaysian Ringgit −0.0197 0.4534 0.0072 0.4526 −0.0611 0.7692 2.8964*** 7.3627***
Maltese Lira −0.0240 0.5569 0.0011 0.5573 −0.0313 0.7811 3.1214*** 4.0294***
Moroccan Dirham −0.0498 0.4227 −0.0148 0.4165 −0.1825 0.6954 4.9699*** 23.8213***
Omani Rial −0.0149 0.0388 −0.0016 0.0191 NA NA 52.5418*** NA
Pakistani Rupee 0.0252 0.2833 0.0239 0.2827 −0.0289 0.5672 −1.1336 48.3722***
Qatari Riyal −0.0092 0.0465 −0.0019 0.0353 NA NA 12.3481*** NA
Romanian Leu −0.0465 0.7672 −0.0076 0.7655 −0.0622 1.1157 3.8562*** 5.4118***
Russian Federation Ruble 0.0256 1.1276 0.0450 1.1229 −0.0998 2.2343 1.2776 9.5509***
Saudi Arabian Riyal −0.0049 0.0323 −0.0009 0.0288 −0.0066 0.0446 9.8021*** 13.8387***
Singaporean Dollar −0.0128 0.3736 −0.0021 0.3733 −0.0221 0.7251 2.1029** 3.9164***
Swiss Franc −0.0169 0.7129 0.0037 0.7126 −0.0205 0.9663 1.5543 1.8289*
Tunisian Dinar 0.0280 0.5333 0.0300 0.5221 NA NA 0.5938 NA
Turkish Lira 0.0469 0.8187 0.0507 0.8187 −0.0396 1.6380 0.6238 14.9491***
UAE Dirham −0.0025 0.0161 −0.0005 0.0156 −0.0019 0.0127 7.5923*** 5.3460***
In this table, we report daily profits (%) from our trading strategies for additional 34 currencies. Refer Table 6 for detail notes.
based predictability results from pre-crisis are almost consistent with what we found when we consider the full sample period. We
have reported the ratio of Theil U statistics less than value one in 56% of cases (19/34 countries), positive OOS_R2 in 59% of cases
(20/34 countries), and positive and significant ENC-NEW statistics in 88% of cases (30/34 countries). These results imply that our
proposed FPM is able to outperform the RWM in more than 50% of 34 countries considered during pre-crisis period.
Finally, we have also reported profits from our trading strategies in Table 12 using data during the pre-crisis period. Overall, we
find that profits obtained from FPM are better than those from RWM and foreign exchange CTM returns. We find positive positives in
56% of cases (19/34 countries) when we consider FPM, whereas RWM and CTM-based profits are reported positive in the case of 35%
(12/34 countries) and 12% (4/34 countries) of countries. For countries where we find negative returns, the negative values from FPM
are smaller compared to RWM and CTM returns. Thus, once again we conclude that irrespective of the sample period considered,
13
Table 11
Robustness test on predictability of other currencies.
Panel A: In-sample predictability test results
Currency Coefficient p-value Currency Coefficient p-value
Argentine Peso −0.0036 0.8186 Kuwaiti Dinar 0.0277 0.1041

Bulgarian Lev 0.0534 0.5619 Latvian Lat −0.0800 0.3275
Chilean Peso 0.4465* 0.0867 Lithuanian Lita 0.0964 0.4369
Chinese Yuan Renminbi 0.0728*** 0.0000 Malaysian Ringgit 0.1107 0.3481
Colombian Peso −0.1640*** 0.0044 Maltese Lira −0.0096 0.9540
Croatian Kuna 0.0299 0.7034 Moroccan Dirham 0.1014 0.1035
Czech Koruna 0.0622* 0.0551 Omani Rial 0.0100*** 0.0000
Danish Krone −0.1165 0.1342 Pakistani Rupee −0.0351** 0.0150
Egyptian Pound −0.0153 0.2514 Qatari Riyal 0.0105*** 0.0003
Hong Kong Dollar −0.0626*** 0.0000 Romanian Leu −0.0243 0.5930
Hungarian Forint 0.0466 0.1754 Russian Federation Ruble 0.0588* 0.0526
Icelandic Krona 0.0563 0.6876 Saudi Arabian Riyal 0.0809*** 0.0000
Indonesian Rupiah −0.0212*** 0.0000 Singaporean Dollar −0.0510 0.1905
Israeli Sheqel 0.0465 0.5836 Swiss Franc −0.1241 0.1729
Jordanian Dinar 0.0689*** 0.0000 Tunisian Dinar 0.1004 0.2559
Kazakh Tenge −0.0072 0.4484 Turkish Lira −0.0495*** 0.0000
Kenyan Shilling −6.5831 0.3786 UAE Dirham 0.0007 0.7106
Panel B: Out-of-sample evaluations.

Argentine Peso 583 0.9998 0.0005 1.1261
Bulgarian Lev 583 1.0003 −0.0005 0.1852
Chilean Peso 583 0.9996 0.0007 2.1611
Chinese Yuan Renminbi 860 0.9125 0.1673 167.0189
Colombian Peso 583 1.0084 −0.0170 −1.8496
Croatian Kuna 583 1.0000 0.0000 0.3638
Czech Koruna 1527 0.9989 0.0022 4.3553
Danish Krone 1527 1.0005 −0.0010 1.2041
Egyptian Pound 583 1.0026 −0.0052 2.7022
Hong Kong Dollar 1527 0.9949 0.0101 16.1807
Hungarian Forint 1420 1.0001 −0.0002 1.2431
Icelandic Krona 583 1.0075 −0.0152 −0.7830
Indonesian Rupiah 1527 0.9959 0.0082 22.7704
Israeli Sheqel 583 0.9989 0.0021 2.6661
Jordanian Dinar 583 1.0785 −0.1632 1.2178
Kazakh Tenge 583 1.0265 −0.0536 6.0286
Kenyan Shilling 583 0.9932 0.0135 5.9617
Kuwaiti Dinar 1527 0.9984 0.0032 12.4951
Latvian Lat 583 0.9996 0.0009 0.3926
Lithuanian Lita 583 0.9998 0.0003 0.4197
Malaysian Ringgit 312 1.0033 −0.0066 0.7336
Maltese Lira 583 0.9995 0.0009 0.6103
Moroccan Dirham 583 0.9983 0.0035 2.3497
Omani Rial 583 1.0327 −0.0664 11.9018
Pakistani Rupee 583 0.9856 0.0285 10.8535
Qatari Riyal 583 1.0013 −0.0026 43.7358
Romanian Leu 583 0.9861 0.0276 11.6429
Russian Federation Ruble 583 1.0007 −0.0015 −0.0743
Saudi Arabian Riyal 1527 0.9836 0.0325 32.0354
Singaporean Dollar 1527 0.9989 0.0021 3.0631
Swiss Franc 1527 1.0007 −0.0013 −0.0502
Tunisian Dinar 583 0.9983 0.0034 2.4649
Turkish Lira 1527 0.9844 0.0310 38.6750
UAE Dirham 1527 1.0587 −0.1208 106.0109
This table reports in-sample (see Panel A) and out-of-sample (see Panel B) predictability test results for other 34 currencies over pre-crisis period. See
Table 5 for detail notes. Finally, *, **, and *** denote statistical significance at the 1%, 5%, and 10% levels respectively.
investors are better off constructing trading strategies using FPM-based forecasting models.
The overall message is worth highlighting regardless of the caveat with respect to the oscillating exchange rate regimes ex-
perienced by these 34 countries. From an economic significance point of view, the exchange rate regime does not matter because we
conclude that the forward premium-based exchange rate model is still superior as was the case with results obtained from the floating
exchange rate regime.
14
Table 12
Robustness test on profits for other currencies.
Argentine Peso 0.0016 0.1918 −0.0031 0.1916 −0.0140 0.3738 −1.2992 3.0028***
Bulgarian Lev 0.0122 0.4806 0.0161 0.4803 −0.0086 0.5312 0.2001 1.2517
Chilean Peso 0.0016 0.5664 0.0281 0.5655 −0.0387 0.6268 1.1353 2.8676***
Chinese Yuan Renminbi 0.0142 0.1155 0.0214 0.1144 0.0086 0.1861 1.8414* 3.2812***
Colombian Peso 0.0779 0.8084 0.0045 0.8091 0.0007 0.9593 −2.2327** 0.1173
Croatian Kuna −0.0177 0.5033 0.0218 0.5016 −0.0373 0.5490 1.9078* 2.8553***
Czech Koruna −0.0054 0.6519 0.0026 0.6506 −0.0511 0.9348 0.5072 3.3832***
Danish Krone −0.0313 0.5423 0.0082 0.5428 0.0081 0.2445 3.3345*** 0.0076
Egyptian Pound −0.0154 0.1374 −0.0019 0.1280 −0.1389 0.1394 2.7537*** 27.8032***
Hong Kong Dollar −0.0027 0.0371 0.0000 0.0371 −0.0005 0.0148 4.7991*** 0.9618
Hungarian Forint −0.0093 0.7572 −0.0202 0.7561 −0.0375 1.1740 −0.6686 1.0626
Icelandic Krona 0.0841 1.0440 −0.0475 1.0477 −0.0297 1.5311 −3.2850*** −0.4459
Indonesian Rupiah 0.0034 0.4549 −0.0017 0.4566 −0.0424 0.9093 −1.5458 12.2749***
Israeli Sheqel 0.0102 0.6150 0.0055 0.6145 −0.0297 0.5145 −0.1904 1.4326
Jordanian Dinar −0.0413 0.0796 −0.0105 0.0723 −0.0755 0.0677 12.1679*** 25.7130***
Kazakh Tenge 0.0142 0.2158 0.0002 0.2166 −0.0088 0.4235 −1.5865 1.0202
Kenyan Shilling −0.0461 0.7603 −0.0195 0.7566 NA NA 0.8819 NA
Kuwaiti Dinar −0.0034 0.0966 0.0055 0.0957 −0.0221 0.1309 3.6749*** 11.4928***
Latvian Lat −0.0143 0.4909 −0.0079 0.4904 −0.0447 0.3277 0.3271 1.8839*
Lithuanian Lita 0.0118 0.4806 0.0276 0.4799 −0.0115 0.5543 0.7956 1.9746**
Malaysian Ringgit −0.0136 0.3750 0.0120 0.3740 −0.0413 0.2955 1.2222 2.5428**
Maltese Lira −0.0244 0.4856 0.0166 0.4804 −0.0289 0.2885 2.0740** 2.3040**
Moroccan Dirham −0.0239 0.4034 0.0297 0.3958 −0.1562 0.5453 3.3116*** 11.4759***
Omani Rial −0.0052 0.0294 −0.0050 0.0244 NA NA 0.2979 NA
Pakistani Rupee 0.0209 0.3906 0.0361 0.3863 −0.0508 0.7739 2.7157*** 15.4710***
Qatari Riyal −0.0127 0.0235 −0.0025 0.0158 NA NA 22.6403*** NA
Romanian Leu −0.0716 0.6879 0.0052 0.6849 −0.0606 0.3074 2.7570*** 2.3631**
Russian Federation Ruble 0.0120 0.2903 0.0214 0.2899 0.0003 0.2524 0.7885 1.7617*
Saudi Arabian Riyal −0.0056 0.0392 −0.0019 0.0353 −0.0069 0.0513 4.7991*** 6.4527***
Singaporean Dollar −0.0227 0.2793 −0.0064 0.2793 −0.0307 0.2630 3.5858*** 5.3298***
Swiss Franc −0.0248 0.6208 0.0111 0.6211 −0.0422 0.9183 2.5019** 3.7190***
Tunisian Dinar −0.0566 0.3608 −0.0176 0.3592 NA NA 3.1269*** NA
Turkish Lira −0.0513 0.8670 −0.0160 0.8634 −0.0294 1.2583 4.4621*** 1.7026*
UAE Dirham −0.0020 0.0179 −0.0011 0.0178 −0.0039 0.0174 3.0021*** 9.3867***
Argentine Peso 0.0016 0.1918 −0.0031 0.1916 −0.0140 0.3738 −1.2992 3.0028***
In this table, we report daily profits (%) from our trading strategies for other 34 currencies over the pre-crisis period. See Table 6 for detail notes.
Finally, *, **, and *** denote statistical significance at the 1%, 5%, and 10% levels respectively.
5. Concluding remarks
The subject of this paper is spot exchange rate return predictability, where the forward premium is used as the predictor variable.
We have a data set covering 16 countries, we use daily historical time-series data and control for persistent, endogenous and het-
eroskedastic predictors. These features of the data have been shown to have a spurious effect on predictability if left unattended. Our
findings are different from the literature. We find that forward premiums predict exchange rate returns for as many as six countries.
Unlike the literature, we discover that for four currencies (AUD, INR, PHP, and THB) forward premiums predict returns positively
while for two currencies (NZD and GBP) predictability is negative. Using a range of OOS predictability tests, we find that at least in
69% of countries there is strong evidence of OOS predictability. When we combine in-sample and OOS evidence, we find: (a) that for
those six currencies (AUD, INR, NZD, PHP, THB, and GBP) that were predictable in-sample are also predictable out-of-sample (except
NZD); (b) out-of-sample tests reveal predictability for an additional six currencies (MXN, NOK, PEN, PLN, ZAR and SEK) which were
not predictable in-sample. Overall, therefore, 75% of the currencies in our sample are predictable; and (c) in the case of four
currencies (CAD, JPY, EUR, and KRW) the evidence of predictability is relatively weak.
We also devise a simple trading strategy where buy and sell signals are generated using predicted and actual exchange rates. The
profits are generated from our model (the FPM), a RWM, and a CTM. The superiority of the FPM over the RWM and the CTM holds
strongly. The EP test, for instance, favours our FPM. The FPM when compared to the RWM sees the EP test to be positive and
statistically different from zero (favouring the FPM) in seven currencies and negative and statistically different from zero (favouring
RWM) in only three currencies. When comparing the FPM with the CTM, the EP test is positive and statistically different from zero in
nine currencies while negative and statistically different from zero in only one currency.
There are two implications of our findings. First, our results support the Clarida and Taylor (1997) finding that, regardless of the
sign of predictability, there is information content in forward premiums that investors can potentially utilise to make profits. Second,
the often-powerful performance of the RWM over fundamentals-based exchange rate models does not hold in our empirical analysis.
Where we discover statistical evidence that forward premium predicts exchange rate returns, we also find that this predictability
15
translates into relatively higher profits compared to a RWM.
Appendix A. Supplementary data
Supplementary data to this article can be found online at https://doi.org/10.1016/j.ememar.2019.100668.
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Emerging Markets Review 42 (2020) 100668

Contents lists available at ScienceDirect

Emerging Markets Review

Predicting exchange rate returns

strategy (see Brunnermeier et al., 2009; and Menkhoﬀ et al., 2012).

2. Empirical framework and econometric approach

2.1. Empirical framework—A motivation

3.1. Data and preliminary analysis

Australian Dollar (AUD) 12/31/1996 5609 −0.00001 0.00769 −0.00164 0.00578

EX FWP-30 EX FWP-30 gamma t-stat p-value

6 lags 36 lags 6 lags 36 lags

AC p-value AC p-value AC p-value AC p-value

ARCH(6) ARCH(36) ARCH(6) ARCH(36)

3.2. In-sample predictability

3.3. Out-of-sample analysis

3.3.1. Statistical measures

Currency 30-day 90-day 180-day 360-day

Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value

Panel B: Out-of-sample evaluations

3.3.2. Trading strategy-based proﬁts

Mean SD Mean SD Mean SD FPM vs RWM FPM vs CTM

3.3.3. Robustness test

Currency Coeﬃcient p-value

Australian Dollar 0.8399*** 0.0000

Panel B: Out-of-sample evaluations.

Mean SD Mean SD Mean SD FPM vs RWM FPM vs CTM

Currency 30-day 90-day 180-day 360-day

Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value

Panel B: Out-of-sample evaluations

Panel A: In-sample predictability results

Currency 30-day 90-day 180-day 360-day

Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value

Saudi Arabian Riyal (SAR) 2804 0.9943 0.0115 30.4139

Mean SD Mean SD Mean SD FPM vs RWM FPM vs CTM

Currency Coeﬃcient p-value Currency Coeﬃcient p-value

Argentine Peso −0.0036 0.8186 Kuwaiti Dinar 0.0277 0.1041

Panel B: Out-of-sample evaluations.

Mean SD Mean SD Mean SD FPM vs RWM FPM vs CTM

translates into relatively higher proﬁts compared to a RWM.

Appendix A. Supplementary data

Supplementary data to this article can be found online at https://doi.org/10.1016/j.ememar.2019.100668.

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