A stochastic approach to modelling the USD/AUD exchange rate: Implications for managing foreign exchange exposure

Abstract

Purpose - To develop all integrated approach to forecasting spot foreign exchange rates by incorporating some principles underlying long-term dependence. Design/methodology/approach - The paper utilises the random-walk framework to develop a stochastic forecast model wherein the sign (positive or negative) and magnitude (strong or weak) of dependence can be separately controlled. The integrated model demonstrates superior forecast performance over a conventional random walk. Findings - Using spot log prices and log price changes (returns) for the USD/AUD exchange rate, the initial outcomes of the study suggest that a priori knowledge of the underlying sign and magnitude of long-term dependence yields out-of-sample forecasts superior to those of a random walk model. Research limitations/implications - Independent assessment of the contribution to forecast accuracy of controlling for the sign of dependence between successive price changes only shows little additional improvement in out-of-sample forecast performance over the random walk null. Practical implications - The findings of the study have important ramifications for managerial finance as they provide important insights on expected future currency returns with potential advantages in currency hedging and/or timing of international capital flows. Originality/value - The contribution of this paper is to develop an original forecast model explicitly incorporating the conceptual and theoretical characteristics of long-term dependent time series. By separating the key characteristics and modelling each individually, the contribution of each to forecast accuracy can be evaluated.