WORKING PAPERS SERIES
WP04-10
Empirical Exchange Rate Models and
Currency Risk:
Some Evidence from Density Forecasts
Lucio Sarno and Giorgio Valente
Empirical Exchange Rate Models and Currency Risk:
Some Evidence from Density Forecasts
Lucio Sarno
!
University of Warwick
and
Centre for Economic Policy Research (CEPR)
Giorgio Valente
University of Warwick
First version: January 2004 - This revised version: August 2004
Abstract
A large literature in exchange rate economics has investigated the forecasting
performance of empirical exchange rate models using conventional point forecast
accuracy criteria. However, in the context of managing exchange rate risk, interest centers
on more than just point forecasts. This paper provides a formal evaluation of recent
exchange rate models based on the term structure of forward exchange rates, which
previous research has shown to be satisfactory in point forecasting, in terms of density
forecasting performance. The economic value of the exchange rate density forecasts is
investigated in the context of an application to a simple risk management exercise.
JEL classification: F31; F37.
Keywords: foreign exchange; forecasting; term structure; density forecast;
nonlinearity.
! Corresponding author: Prof. Lucio Sarno, Finance Group, Warwick Business School, University of Warwick,
Coventry CV4 7AL, UK. Tel: +44-2476-528219; fax: +44-2476-572871. Email: lucio.sarno@warwick.ac.uk
Postal address of co-author: Dr Giorgio Valente, Finance Group, Warwick Business School, University of
Warwick, Coventry CV4 7AL, UK.
2
1. Introduction
Exchange rate risk plays a major role in international portfolio diversification and in
several aspects of economic policy, including the assessment of the uncertainty surrounding
prices of exports and imports, the value of international reserves and open positions in