Exchange Rates and Fundamentals: A New Look at the Evidence on Long-Horizon Predictability

<Para ID="Par1">A widely held view in finance is that there is predictability in stock returns, bond returns, and exchange rates and that this predictability increases with the forecast horizon. Conventional tests for long horizon predictability may reject the null too frequently when the predictor variable is highly persistent and endogenous and there are overlapping observations creating unintended autocorrelation errors. We use a recently developed econometric technique to investigate predictability in short versus long horizon exchange rates. This procedure negates the historical bane of overlapping data i.e., the autocorrelation problem. This metric has strong and stable asymptotic properties even in small samples. We conduct extensive examination across a broad spectrum of time horizons, and find that the evidence for predictability is not as strong as previously stated. Copyright International Atlantic Economic Society 2015