A Twofold Model for Exchange Rate Forecasting: Combining Fundamentals and Market Dynamics

Abstract

This paper offers a fresh perspective on exchange rate determination by incorporating both microstructural and macroeconomic variables, aiming to bridge the gap between traditional economic theories and the more recent microstructure approaches. The study tests a combination of fundamental economic factors and microstructure elements within a cointegration framework, analyzing their joint impact on exchange rates across multiple currencies. By doing so, it provides a more comprehensive model that captures both long-term economic fundamentals and short-term market-specific dynamics. The "twofold" model proposed in this study integrates macroeconomic fundamentals, including interest rates, money supply, and net foreign assets, with microstructural variables such as the bid-ask spread and high-low spread. Macroeconomic fundamentals represent the broader economic forces traditionally thought to drive exchange rates, while microstructure variables capture the liquidity, transaction costs, and trading behavior within foreign exchange markets. The inclusion of microstructure variables recognizes the significance of market-specific factors that influence currency values in the short term, providing a more nuanced understanding of exchange rate movements. To evaluate the performance of the twofold model, it is compared with conventional macroeconomic models and the widely used random walk model through an error-correction framework. The error-correction method allows the study to analyze both short-term deviations and long-term equilibrium relationships, making it particularly suited for examining the cointegration of exchange rates with their determinants. The analysis includes both in-sample and out-of-sample forecasting tests to ensure the robustness of the findings. The results of the study demonstrate that the twofold model outperforms both the macroeconomic models and the random walk model in forecasting exchange rates. In both in-sample and out-of-sample tests, the twofold model provides greater predictive accuracy, highlighting the value of integrating microstructural variables into exchange rate models. This suggests that the traditional macroeconomic approach alone may not fully capture the complexities of exchange rate behavior, particularly in the short term where market dynamics play a significant role. The findings have important implications for both academic research and practical applications. For researchers, the study underscores the need to consider microstructural factors alongside economic fundamentals when modeling exchange rates. This integrated approach could lead to more accurate and reliable models that better reflect the realities of foreign exchange markets. For policymakers and market participants, the results provide valuable insights into the drivers of exchange rate movements, potentially aiding in the design of better monetary policies and trading strategies. By introducing a more comprehensive framework for exchange rate determination, this paper contributes to the ongoing evolution of exchange rate modeling. It challenges the traditional reliance on macroeconomic fundamentals alone and highlights the importance of incorporating market-specific dynamics. Future research could build on this work by exploring additional microstructure variables or applying the twofold model to other financial markets, further enriching the understanding of the interplay between macroeconomic and microstructural factors in determining exchange rates.