An Exchange Rate Forecasting Model when the Underlying Currency is Pegged to a Basket

An ARDL model is estimated and subsequently used to forecast the exchange rate of the Kuwaiti dinar (KD) against the U.S. dollar. It is demonstrated that this exchange rate is related to the exchange rates of the yen, mark and pound against the dollar in accordance with the arrangement of pegging the KD to a basket of currencies with undeclared components. It is also shown that market forces cause the exchange rate to deviate from the level implied by this arrangement. The proposed model outperforms the random walk and the forward rate in out-of-sample forecasting.