The Random Behavior of Flexible Exchange Rates: Implications for Forecasting
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the International Money Marketin Chicago, where private individualsof reasonablemeans now can buy and sell standardizedfuture contracts in major currencies. Formerly, pressure from the FederalReserveBoardand occasional operationalproblems effectively prevented U.S. banks from accommodating individualswho wished to "take a view" on the future of a currency. These developments,plus the stringof spectacularlosses incurred by the foreign exchangetradingoperations of major banks which came to light during 1974, in combination with the fundamental changes in the international monetary environment that have occurred since the late 1960s, reviveinterest in the possibility of successfullypredictingexchange rates. In general,forecasting economic data requiresthe presumptionof a set of relationshipsamong variables, one of which is the variableto be forecast.1 Economic forecasting, in other words, requiresa model. Such a model may be in unspecified form in the back of the mind of a person who has been a long-termobserverof the processeswhich generatethese data.In many forecastingmethodsthe relationshipscomprisingthe model arestated in explicit mathematicalterms, as in the case of econometricmodels. Forecasting techniques based on formal models may rely on an assumed sequence of causal relationships(e.g., simulation models), or on the databased development of statistical relationshipsbetween the variableof interest and past valuesof the sameseries(intrinsicmodels) and/orpast valuesof variousexogenous variables(extrinsicmodels). The widespread availability of computer facilities, permittinghuge amounts of datato be manipulated,has fosteredthe proliferationof statistical forecastingtechniques. Exogenous models of this type usuallyendeavor to employ accepted economic relationshipsin developing a model which is then refined through statistical analysis of historical data. Typical of these models in the case of exchange rate forecasting is one that has been described by Gray.2 The model attempts to predictchangesin exchange rates by meansof a two step isolation of factors. First, exchange ratesaredefined as the product of trade flows between countries. Second, changes in trade flows are defined to be the product of relativemovementsof the industrial production index and consumer price indicesof the countriesinvolved.The author also notes that "the critical question is not how many of the factors (active) in the foreign exchange market does this model incorporate?"but rather"how accuratea predictorof foreignexchange ratesis the model?" Intrinsic forecastingmodels, relying only on tie past sequence of the same series, are less widely employed for obvious reasons. Nevertheless, recent developments in time series theory have led to the frequent use of methods which forecast by fitting some functionalrelationto the historical valuesof the series and extrapolatingthem into the f
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