Can currency-based risk factors help forecast exchange rates?

This paper examines time-series predictability of bilateral exchange rates from linear factor models that utilize unconditional and conditional expectations of three currency-based risk factors. Exploiting a comprehensive set of statistical criteria, we find that all versions of the linear factor models largely fail to outperform the benchmark of random walk with drift model in the out-of-sample forecasting of monthly exchange rate returns. This holds true for individual currencies and currency portfolios formed on forward discounts. We also show that the information embedded in the currency-based risk factors does not generate systematic economic value to investors