“The US$/€ exchange rate: Structural modeling and forecasting during the recent financial crises”

by Claudio Morana: CeRP WP 155/16

The paper investigates the determinants of the US$/€ exchange rate since its introduction in 1999, with a special focus on the recent subprime mortgage and sovereign debt financial crises. The econometric model is grounded on the asset pricing theory of exchange rate determination, which posits that current exchange rate fluctuations are determined by the entire path of current and future revisions in expectations about fundamentals. In this perspective, we innovate the literature
by conditioning on Fama-French and Charart risk factors, which directly measures changing market expectations about the economic outlook, as well as on new financial condition indexes and a large set of macroeconomic variables.
The macro-finance augmented econometric model has a remarkable in-sample and out of sample predictive ability, largely outperforming a standard autoregressive specification neglecting macro-financial information. We also document a stable relationship between the US$/€-Charart momentum conditional correlation (CCW) and the euro area business cycle, potentially exploitable also within a system of early warning indicators of macro-financial imbalances. Comparison with available measures of economic sentiments shows that CCW yields a more accurate assessment,
signaling a progressive weakening in euro area economic conditions since June 2014, consistent with the sluggish and scattered recovery from the sovereign debt crisis and the new Greek solvency crisis exploded in late spring/early summer 2015.

Published: January 2016