Euro-Dollar Exchange Rate: An

Econometric Approach
Econometrics

Afonso Brites, 12564

Sebastio Fernandes, 12479
Miguel Leal, 12609
Pedro Tom, 12723
Lisbon, 2015

Introduction
The issue of forecasting the euro-dollar exchange rate is obvious. At the moment
its the most important currency pair in the FX market and its fluctuations are important
for both major economic transactions between the two biggest game players (Eurozone
and US) and for the peripheral economies that rely on this exchange rate for some parity
maintenance of their currency. The euro was introduced on January 1, 1999, but its use
by consumers in retail transactions started on January 1, 2002. That means that only
sixteen years have passed since the first date and thirteen since the second.
Consequently, both ECB and the economic agents have been involved in a learning
process about the mechanisms of transmission of the monetary policy and its effects on
the economy of its own countries as in the economy of member countries and the role of
the euro as an international currency.
This paper's study centres on the following question: "Is it possible to predict
next month's exchange rate with some accuracy?" In order to do so, we focused on
macroeconomic fundamentals that represent the best arguments in our possession to
figure out what would be the best-fit set of explanatory variables. Its investigation relies
on the relation between each variable according to the one in the other zone. To solve
this problem we based our explanatory variables in differentials: money supply
differentials, interest rate differentials, inflation differentials, 3m bond yields
differentials, and GDP differentials. Only this set of variables would allow us to relate
the movements of the economies across seas in a parallel way.
The main limitation the literature has faced was in the measure of the GDP as its
data is quarterly based, but we could verify that a mixture of frequencies was already
used in past papers.

Literature Review
Exchange rates forecast has been a theme of enormous interest regarding the
international finance area, considering that both professional and academic resources
are focused on this task. In order to fulfill all of the areas that we wanted to cover, it was
of crucial importance to analyze several papers. We went from the ones that broadcast
our theme in a more general way to those that tried to explain the relevance of the
inclusion of our first set of variables. Such analysis is subscript below in a very
segmented manner:
First of all let's focus our attentions in what variables to include in the model.

Regarding Maeso-Fernandez, Osbat and Schnatz's study that relies on the determinants
of the euro effective exchange rate the results indicated that the differentials between
real interest rates and productivity have significant influence on the euro effective
exchange rate as well as the terms of trade shocks due to the oil dependence of the euro
area. In some instances, the relative fiscal stance and terms of trade also have a
noteworthy effect. Interest rate differentials can easily be included in our regression,
although it would make more sense to include nominal rates as opposed to real interest
rates. As for the productivity, this paper uses differentials of an index, which divides real
GDP by the number of employees of a particular important trading partner. This data is
easily obtained for the EU and US and can also be included in our study as an
independent variable. An alternative method of measuring productivity would be
through GDP growth differentials. Synthetic data was compiled for the euro area by
aggregating the data from different EU countries using trade weights.
Concerning the short run prediction we looked for fundamentals-based models
for the euro-dollar rate mixing economic variables quoted at different frequencies. This
mixture of frequencies allowed assessing the influence of macroeconomic variables
quoted at monthly frequency and not available at weekly frequency over weekly
movements in the FX rate. Such robust choice was made under the contributions of
Mariano and Murasawa (2003) and Camacho and Perez-Quiros (2010) who use
maximum likelihood factor analysis of time series with mixed frequencies, handling
quarterly series as monthly series with missing observations. We also believe that this is
an important factor backing up our quarterly data regarding the GDP. The model
acquires great improvement and advantage against random walk models by the use of
the trend of change metric, much more appropriate than any other loss measures.
Following the study of Jansen and De Haan on the Effect of European Central
Bank and National Central Banks statements on the euro-dollar exchange rate it is
possible to conclude that ECB statements have a large influence in the conditional
volatility and in some cases, the conditional mean as well. Such study might be of
interest to our model if ECB statements were to be classified as dummy variables upon
the degree of importance. However, given that the analysis of ECB's statements for this
paper concerned a time frame half as big as ours it would be too time-consuming to
include such a hard working variable.
In order to verify one of the most important inferences, out-of-sample
forecasting accuracy, Meese and Rogoff concluded that structural models fail to
improve on the random walk model despite the fact of the forecasts being based upon
realized values of future explanatory variables. This derives from the failure of out-of-

sample estimates by the time series models. The vector auto regression implies that
major-country exchange rates are well predicted by a random walk model (without
drift). However, the failure of structural models to outforecast the random walk model is
less certain to be attributed to sampling error.
Ehrmann, Fratzscher and Rigobon estimate the financial transmission between
money, bond and equity markets and exchange rates within and between the USA and
the euro area. US financial markets explain on average around 30% of movements in
euro area financial markets, whereas euro area markets account only for about 6% of
US asset price changes. The methodology used, allowed them to identify indirect
spillovers through other asset prices, which are found to increase substantially the
international transmission of stocks within asset classes. In this case, international crossmarket spillovers are significant. However, regarding our model, we believe that these
kind of shocks are well represented by inflation differentials and bond differential that
sustain the major information of financial markets in the most broad and stable manner.

Conceptual framework
To explain the variation in the exchange rate between the US Dollar and the
Euro, we applied economic fundamentals that are based on macroeconomic reasoning.
There are many different theories of exchange rate determination, but most perform
quite poorly at forecasting. For this reason, we included variables from each of these
approaches and added other variables we considered to be important too. (When we use
the term spot rate or exchange rate, we will always be referring to the exchange rate
between the Euro and the US Dollar - /$)
Prices of goods are a crucial determinant of the exchange rate. If US prices are
lower than EUs, people from the EU will start buying products outside because it's
cheaper. This increases the demand for US products driving their prices up, and, at the
same time, as their products are dollar denominated, we have to exchange euros for
dollars to buy them, which appreciates the dollar. Both of these effects contribute to
more expensive foreign products from the EU's point of view, though they would still be
cheaper than ours. This process occurs several times, gradually reducing the price gap
until the exchange rate (/$) stabilizes at a higher level. Assuming that transportation
costs are very low, if an economic area has a higher level of inflation than the other, the
exchange rate will move in order to offset that disequilibrium, meaning that the
currency should depreciate relative to currencies with a lower level of inflation.

Interest rates have two different effects, but both that take place in different time
periods. In the short-term, if, for example, the EU has lower interest rates than the US,
there will be a capital outflow to the latter, as people can easily get higher returns there.
That outflow would mean that investors exchange euros for dollars to buy the desired
securities, pushing the dollar's value up (the current spot rate increases). On the other
hand, as investors want to bring the money back home to buy goods, they will trade the
dollars back to euros. If arbitrage is still possible, investors will continue to buy dollars
now and selling them in the future, sending the forward rate (the price at which foreign
exchange is quoted for delivery at a specific future date) downwards. It's easier to
understand with an example. Assume that both the current spot rate and forward rate
one year from now are 1/$ and that the EU and US interest rates are respectively, 2%
and 6%. If we have 1 euro we can exchange it for dollars, invest it in the US, sell 1,06
dollars forward at a rate of 1/$, wait one year, collect the 1,06 dollars (principal plus
interest payments) and trade it back to euros at the arranged forward rate. This method
would yield 1,06 instead of 1,02 we would get investing in the EU. As other investors
see the opportunity for riskless profit, they would use the same mechanism, selling more
and more dollars forward and decreasing the forward rate. This would gradually reduce
the margin for profit and subsequently eliminate it altogether. Since the forward rate is,
under the efficient market hypothesis, an unbiased estimator of the future spot rate, we
expect a spot rate decline. "If home and foreign bonds are perfect substitutes, and
international capital is fully mobile, the two bonds can only pay different interest rates if
agents expect there will be a compensating movement in the exchange rate"- Second
Annual IMF Research Conference Kenneth Rogoff. In conclusion, imagine for some
reason that ECB announces quantitative easing. As prices are temporarily fixed, and so
is the GDP, the only way to reach an equilibrium is for euro area interest rates to go
down. Consequently, there will be an instantaneous capital outflow that would cause an
excessive depreciation of the euro (appreciation of the dollar). But as EU interest rates
are lower than in the US, investors expect the currency to appreciate to compensate for
lower returns. A lower EU interest rate compared to its initial value implies a higher
quantity of transactions and, thereby a higher demand that drives prices up. That will
cause the real supply of money to go down, pushing interest rates up again. Higher
interest rates mean shrinking the interest rate differentials and lower pressure for
currency appreciation until there are no more arbitrage opportunities, which is when the
exchange rate reaches equilibrium. For this reason the initial fall in the currency value
overshoots its eventual equilibrium level.

The difference between the expected returns on stocks in the EU and the US too,
play a role in the exchange rate determination, because investing is not confined to
buying bonds. One can wonder whether the effects would be identical to that of interest
rates, but this isnt entirely true. As we cannot observe returns before they happen, we
expect that the capital inflow in the short-run wont be so abrupt. Therefore the shortterm effect is expected to be similar but weaker than what was previously described and
the long-term effect is expected to be same.
The growth of the EU versus US money supply is also one of the determinants
of the exchange rate. But why is it important? Let's focus again on a EU expansionary
monetary policy. If money supply goes up, "domestic" prices will go up as foreign
prices remain fixed, which, as it was earlier explained, causes a euro depreciation. This
implies that if the money supply is growing faster in the EU than in the US our currency
will depreciate over time (there should be no immediate effect because prices are
sticky).
The last factor that we assume to be relevant is the relative economic growth
rate. If a nation exhibits a high growth rate, it will attract investment that seeks to
acquire domestic assets. So if that same nation has a higher growth rate relative to
others it will attract more investment than the latter, increasing the demand for its
currency by more than the demand for foreign currency, leading to an appreciation of
the first.1

Data
Only post-2008 euro-dollar exchange rates are part of the sample that we used to
estimate the model. The sample has monthly frequency, starts on January 1, 2009 and
ends on December 31, 2014, encompassing a total of 72 observations. One may be wary
about the choice of such a small number of observations, but it wasnt really a choice
because, only on October 8, 2008 the ECB announced that main refinancing operations,
would be carried out through a fixed-rate procedure, which didnt happen before.
Therefore analyzing data before that point in time would be much more complicated as
rates were variable. At the same time, we also wanted to be able to compare our
predictions with the true values, and so we stop collecting data as far as December 31,
2014.

1 Consult figure 1 in the appendix as it represents a summary of all the effects

Regarding the Real GDP, as its only released quarterly, our data had different
frequencies. We tried to fix this problem by assuming a constant growth intra-quarter,
even though that might not be totally realistic.
The model that follows is the first we are going to estimate in the subsequent
section.
Logeurdolt = 0 + 1Logeuusmst-1 + 2Intdifft + 3Intdifft-1 + 4Infdifft-1 +
5Indexdifft + 6Indexdifft-1 + 7Rgdpdifft-1 + ut
The explained variable is the natural log of the exchange rate, which is
expressed as a ratio of Euro per unit of US Dollar and the first explanatory variable is
the log of the proportion of Euro area money supply (M2) to US money supply (M2)
with one period lag. We chose to use natural logs for both of these variables because it
leads to coefficients with more appealing interpretations how a percentage change in
one variable will impact the other, also measured in the form of a percentage change.
For example, if the money supply in Europe outgrows United States by 1 percent that
would increase/decrease the exchange rate by 1 percent). As variables are strictly
positive taking logs wont generate any problem2. Also, regarding the dependent
variable, taking the log can, to a certain extent, mitigate the problem of
Heteroskedasticity if theres any.
The remaining explanatory variables are the interest rate, inflation rate, stock
index return and real GDP growth differentials between the EU and the US, respectively
(each of them lagged one period). Additionally, the variables Intdifft and Indexdifft were
included in the model because, as it was previously explained, theyre the only variables
that are expected to have immediate effects in the exchange rate.
We should also mention that all the variables, except the exchange rate, interest
rate differentials and stock index return differentials, are seasonally adjusted. They
shouldnt be adjusted anyway because they dont exhibit seasonality. Regarding this
adjustment, theres a chance that it causes a distortion in the parameter estimates
because its unclear whether all the variables were adjusted by the same method or not,
as R. A. Meese and K. Rogoff denoted in Exchange rate models of the seventies.

2 There could have been a problem with the use of the logarithmic
transformation if variables were too close to zero, as it would alter the
magnitude of the variables excessively, which is not the case.

In the next section, you might be unsure about whether we forgot about the
interest rate differential in our model. Thats not the case. We simply found out, through
the results of our analysis, that the yield differential of German and US 3-month bonds
(we named that variable Bonddiff), would be the best proxy of the interest rates in both
economies, since the ECB and FEDs fund rates or base rates resulted in parameter
estimates that werent neither as consistent with our macroeconomic rationale nor as
statistically significant. But if we are comparing the interest rates in EU and US how
can Germany be representative of the entire Euro area? As Germany is one of the largest
bond markets in the world, its the closest thing to a Euro area bond that is.
Most of the data was collected from the ECB, FRED of St. Louis, OECD and
Investing.com databases.

Model
Logeurdolt = 0 + 1Logeuusmst-1 + 2Bonddifft + 3Bonddifft-1 + 4Infdifft-1 +
5Indexdifft + 6Indexdifft-1 + 7Rgdpdifft-1 + 8t + ut
Before we estimated the model we noticed that both logeurdol and logeuusms
series had noticeable trend and as a result we might have run into a spurious relationship
between them, which would create a spurious regression problem. Adding a trend can,
to a certain extent, solve this problem.
We also created a dummy variable for the period after the famous Mario
Draghis speech where he pledged to do whatever it takes to save the Euro. The main
purpose was to find out if it caused an upward pressure in the Euro. Although
statistically we found that it was not significant, if we look at the exchange rate over
time we can see clearly that it had a great impact in the period immediately after the
speech and some months that followed 3. We believe that the reason behind the nonsignificance is that the trend inverted somewhere April 2014, probably because markets
started to think that Quantitative Easing was a possibility.
We proceeded with the removal of the variable Indexdiff t and its lag because
they were not significant when introduced separately in the model. As they could be
jointly significant we also did an F-Test, which resulted in non-rejection of the null

3 See figure 2

hypothesis4. Regarding the economic significance, Indexdifft-1 had an unexpected sign,

which further supported our decision to remove the variable.
Since the main goal of our project is to predict future values we are going to use
an AR model.
In order to find a suitable number of lags we plotted a partial correlogram with
95% confidence bands and concluded that there should be no more than one.
Thus, heres our final model:
Logeurdolt = 0 + 1Logeuusmst-1 + 2Bonddifft + 3Bonddifft-1 + 4Infdifft-1 +
5Rgdpdifft-1 + 6Logeurdolt-1 + 7t + ut

Violation of Assumptions
After arriving at our model, it had to be tested for any possible violation of
assumptions and corrected accordingly. Firstly, the Classical Assumptions were tested.
The assumptions linearity in parameters and no perfect collinearity werent tested
because we already took these into account when making the model.
The important assumption to test was strict exogeneity because without it, we
cannot guarantee unbiasedness of the estimators. We ran a regression of the residuals
against the independent variables for different time periods 5 and noticed that the
residuals were in fact correlated with the independent variables (in t-1, for example).
Because we now know that this assumption was violated, we had to move onto the
Asymptotic Assumptions.
The first test for asymptotic properties was stationarity. We ran the DickeyFuller test for each of the variables 6 and noticed that logeurdol, l1logeurdol and
l1logeuusms were not stationary. In order to correct this, we used first difference for
each non-stationary variable and repeated the Dickey-Fuller to confirm7. Conveniently,
the same Dickey-Fuller test also allowed us to conclude that we have weak dependence
and therefore the first assumption holds.
4 See figure 3
5 See figure 4
6 See figure 5
7 See figure 6

After guaranteeing stationarity and weak dependence, we moved onto

contemporaneous exogeneity. We ran the residuals of the new regression on the new
model8 (with first differences of the previously non-stationary variables) in period t
(only) and concluded that the assumption holds. Because we already know we have no
perfect collinearity, we can conclude we have consistency of the estimators.
In order to achieve valid inferences, we still had to check for serial correlation
and heteroskedasticity. For serial correlation, we couldnt use Cochrane-Orcutt test
because we didnt have strict exogeneity. Instead, we ran a regression of the residuals
(with robust standard errors) against the independent variables and lagged residuals 9.
We found no evidence for serial correlation, as the p-values for the variables were too
high. This was probably corrected when we introduced the first differences into the
model.
Finally, we ran the Breusch-Pagan test and the White test 10, finding no evidence
of heteroskedasticity, as well as an ARCH test 11 to make sure no ARCH effect was
verified. Having TS.1 TS.5 verified (asymptotic normality is implied), we now had
asymptotically efficient estimators and the usual inference procedures were
asymptotically valid.

Results
After fixing the problems of our model we still decided to drop two variables
the first difference of the natural logarithm of the money supply ratio (lagged one
period) and the GDP growth rate differentials (also lagged one period) because, even
though the signs of the coefficients were as expected according to macroeconomic
theory they were neither statistically nor jointly significant).
This is our actual final model12:

8 See figure 7
9 See figure 8
10 See figure 9
11 See figure 10
12 Consult figure 11 in the appendix

13

D1Logeurdolt = 0 + 1Bonddifft + 2Bonddifft-1 + 3Infdifft-1 + B4D1Logeurdolt-1 + ut

The interpretation of the coefficients is the following:

1 An increase in the current Bond yields differential by 1 percentage point leads to a
9,97 percentage points decrease on the growth rate of the spot rate, on average ceteris
paribus.
2 The increase in Bond yields differential a month ago by 1 percentage point leads to
an 8,46 percentage points increase on the growth rate of the spot rate this month, on
average ceteris paribus.
3 The increase in inflation differential a month ago by 1 percentage point leads to an
increase of 6,92 percentage points on the growth rate of the spot rate this month, on
average ceteris paribus.
4 An increase of 1 percentage point on the growth rate of the spot rate from the
month before will decrease the current value of the growth rate of the spot rate in 0,34
percentage points, on average ceteris paribus.
We should mention that the dependent variable is the first difference of the log,
which is basically a growth rate measured in a percentage change. But when interpreting
a coefficient of an independent variable we are looking at how much this variable
changes the growth rate, and so we must interpret it as percentage points.
All the effects are as expected if we apply the reasoning that was described in
the previous sections. The reason behind the negative coefficient of the spot rate growth
(lagged one period) is that people tend to overreact to economic shocks. This
phenomenon is called overshooting and it was also explained previously.
In our final model, all variables are statistically significant (the P-values are less
than 5%) and the regression is overall significant (the P-value of the F-test test is equal
to 0.01%).14 The R2 is about 0.2954, which means that roughly 30% of the variation of
the spot rate growth can be explained by our model. Although this is not a very high
value we need to pay attention to the fact that it is extremely difficult to find excellent
13 When we write D1 before a variables name that represents its first
difference
14 Consult figures 11 and 12 in the appendix

models that predict variables related to financial markets. Otherwise, one could easily
get rich.
Since there were some papers that suggested that the exchange rates follow a
random walk we thought that it could be interesting to check how it would perform
against our model.
A random walk is the sum of the lagged dependent variable and an error. We
estimated that error by getting the residuals of our final model and creating an AR (1)
with them. After that, we added the resulting errors to the lagged dependent variable in
order to get a random walk.
The R2 of this random walk is equal to 0.3797 15, which is greater than our
models (0.2954). That is, a random walk can explain the exchange rates growth rate
than it.
To perform a forecast we needed to compute ARMA models in order to predict
future values for the independent variables.
To test the accuracy of our forecast for the spot rate we generated a confidence
interval around it for January, 2015 (one-step ahead) and check if the real value was
within this range (where the null hypothesis is for the forecast and real value to be
equal). However we only had the standard errors for the predictions of the exchange rate
growth, not for the exchange rate itself. 16 Therefore we estimated a confidence interval
for the growth and then applied the upper and lower limit of that growth to the spot rate
of the previous month.
The obtained confidence interval, with a confidence level of 95% resulted in
growth rates between [0.52%, 3.91%]. By applying these growth rates on the spot rate
of the previous month we obtain a confidence interval (with the same significance level)
for the predicted spot rate of [0.831; 0.859]. Given that the observed value was 0.886
(outside the interval) it means that we reject the null hypothesis. We also perform the
test for a higher confidence level (99%) and the result was the same. This means that
even with 99% confidence, our forecast for the spot rate of the following month failed.
This has most likely something to do with the unusual change in the spot rate between
December and January (over 7%). This sudden change was due to the fact that people
anticipated the quantitative easing policy, which would be conducted afterwards by the
ECB.

15 Consult figure 13 in the appendix

16 Consult figure 14 in the appendix

Conclusions
The objective of this work has been to propose a model that could estimate the
euro-dollar exchange rate. This paper is based on a very comprehensive and consistent
data set for both Eurozone and the US, which has been compiled for the period from the
beginning of 2009 until the end of 2014. The selection of the explanatory variables of
the euro exchange rate follows the most relevant theoretical models as shown in the
literature review. These take into account the money supply differentials, interest rate
differentials, inflation differentials, 3m bond yields differentials, and GDP differentials.
Too much differentials? It might sound like, but after careful revision, the reader can
conclude by himself that regarding the study of an exchange rate, two zones are
interacting. For this fact, it is quite natural to include the differentials as an explanatory
variable since it measures the contemporaneous difference between the two zones.
After ending up with a pretty significant model, the hypothesis test made to the
predicted value, in which was rejected that the predicted value and the real one were
equal, serve us as an example of the problem of these kind of models who seek to
explain and predict the values of financial variables. Many analysts and investors, who
deeply trust in quantitative models that have 95% and 99% confidence intervals, end up
loosing too much money by disregarding the market awareness of unpredictable
fundamentals.
However, these results are promising and might hopefully give place to further
research. In particular, we highlight some possible extensions of this paper: The
inclusion of other variables such as announcements made by the BCE or by country
representatives (of every country in the euro area) that we believed to be impactful.
Symmetric to this it would also be important to include announcements made by the
Federal Reserve. In a particular way, the inclusion of statements made by the two zones,
would allow to check the impact difference of each Central Bank.
The data didn't support our premise as we rejected the hypothesis that the
prediction for the exchange rate is equal to the actual exchange rate. Despite all this, we
are aware that such rejection can be related to the quantitative easing policies practised
by both Central Banks. It would be of interest to include some dummy variables
characterizing the kind of QE measure in use.
Econometrics can be useful, but models aren't perfect.

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Appendix
Figure 1-Determinants of the exchange rate

Figure 2 Saving the Euro

Figure 3 Testing multiple exclusion restrictions

Figure 4 Strict exogeneity

Figure 5 - Stationarity

Figure 6 Stationarity (corrected)

Figure 7 Contemporaneous exogeneity

Figure 8 Serial Correlation

Figure 9 - Heteroskedasticity

Figure 10 ARCH test

Figure 11 - Final Model

Figure 12 - Three Models

Figure 13 - Random Walk

Figure 14 - Prediction One -Step Ahead