Forecasting exchange rates using principal components

Natalia Ponomareva, Jeffrey Sheen, Ben Zhe Wang*

*Corresponding author for this work

Research output: Contribution to journalArticle

Abstract

We introduce a novel atheoretical approach to forecasting bilateral exchange rates. We first obtain principal components for a set of up to 20 bilateral exchange rates for a set of major currencies of interest. We then fit autoregressive processes to get one-period-ahead forecasts of each of the principal components and use these to forecast individual bilateral exchange rates. We focus on six major currencies, including the US dollar, Japanese yen, British pound, euro, and the Australian and Canadian dollars. Based on the daily data from 01/02/1999 to 08/03/2018, our results suggest this approach can be useful in forecasting some one-day and one-month ahead bilateral exchange rates, particularly for the pound and Australian dollar. The optimal number of principal components that should be included in the forecasting procedure depends on the currency of interest.

Original languageEnglish
Article number101131
Pages (from-to)1-12
Number of pages12
JournalJournal of International Financial Markets, Institutions and Money
Volume63
Early online date3 Sep 2019
DOIs
Publication statusPublished - Nov 2019

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Keywords

  • Bilateral exchange rates
  • Forecasting
  • Principal component analysis

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