Forecasting of foreign exchange rate by normal mixture models

Develops a method of forecasting foreign exchange rate by normal mixture model (NMM). Initially establishes a set of exchange rate models and switches from one model to another probabilistically, depending on supply shocks or government policy changes. By assuming that the population distribution of foreign exchange rate is a mixture of normal distributions, these models can then be estimated simultaneously. Uses the estimated parameters of the model to forecast foreign exchange rate, and then four foreign exchange rate models are used to estimate the NMM. The out‐of‐sample forecasting results obtained show that we can decrease the mean squared error (MSE) of forecast error dramatically by using the NMM, compared with the MSE of the best forecast of each separate model.