On the Sources of Uncertainty in Exchange Rate Predictability

We analyse the role of time-variation in coe¢ cients and other sources of un- certainty in exchange rate forecasting regressions. Our techniques incorporate the notion that the relevant set of predictors and their corresponding weights, change over time. We Önd that predictive models which allow for sudden, rather than smooth, changes in coe¢ cients signiÖcantly beat the random walk benchmark in out-of-sample forecasting exercise. Using an innovative variance decomposition scheme, we identify uncertainty in coe¢ cientsíestimation and uncertainty about the precise degree of coe¢ cientsívariability, as the main fac- tors hindering modelsíforecasting performance. The uncertainty regarding the choice of the predictor is small.