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Can Fluctuations in the Consumption-Wealth Ratio Help to Predict Exchange Rates

J. Internacional: Can Fluctuations in the Consumption-Wealth Ratio Help to Predict Exchange Rates

VICENTE TUESTA., JORGE SELAIVE C.

2005 - Applied Financial Economics - Vol. 16, N° 17, Pp 1251 - 1263

Abstract

It is well documented that macroeconomic fundamentals are little help in predicting changes in nominal exchange rates compared to the predictions made by a simple random walk. Lettau and Ludvigson (2001) find that fluctuations in the common long-term trend in consumption, asset wealth, and labor income (hereby, consumption-wealth ratio) is a strong predictor of the excess returns. In this paper, we study the role of the consumption-wealth ratio in predicting the change in the nominal exchange rate of a large set of countries. We find evidence that fluctuations in the consumption wealth ratio help to predict in-sample all the currencies. In terms of out-of-sample forecasts, our results suggest that the consumption wealth ratio may play a significant role predicting the Canadian dollar at all horizons and at short-intermediate horizons for some currencies.

Keywords

Exchange Rates, Consumption-Wealth Ratio, Predictability

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