City Research Online

Abstract

We examine the relationship between exchange rates and macroeconomic fundamentals using a two-step maximum likelihood estimator through which we compute time-varying factor loadings. Factors are obtained as principal components, extracted from vintage macro-datasets that combine FRED-MD and OECD databases. Using 14 currencies over 1990–2021, we show that the loadings on the factors vary considerably over time and increase the percentage of explained variation in exchange rates by an order of magnitude. Time-varying loadings improve the overall predictive ability of the model, especially during crises, and lead to better forecasts of sign changes in exchange rates.

Publication Type:	Article
Additional Information:	This is the peer reviewed version of the following article: Hillebrand, E., Mikkelsen, J., Spreng, L. & Urga, G. (2023). Exchange Rates and Macroeconomic Fundamentals: Evidence of Instabilities from Time-Varying Factor Loadings. Journal of Applied Econometrics, which will be published in final form at http://onlinelibrary.wiley.com/journal/10.1002/(ISSN)1099-1255. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Use of Self-Archived Versions. This article may not be enhanced, enriched or otherwise transformed into a derivative work, without express permission from Wiley or by statutory rights under applicable legislation. Copyright notices must not be removed, obscured or modified. The article must be linked to Wiley’s version of record on Wiley Online Library and any embedding, framing or otherwise making available the article or pages thereof by third parties from platforms, services and websites other than Wiley Online Library must be prohibited.
Publisher Keywords:	oreign exchange rates, macroeconomic factors, time-varying loadings, high-dimensional factor models, exchange rate forecasting
Subjects:	H Social Sciences > HB Economic Theory
Departments:	Bayes Business School > Finance
SWORD Depositor:	Symplectic Administrator

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