Exchange rate dynamics, forecasting and the microstructure approach: empirical evidence for an emerging market economy

Abstract

This article investigates exchange rate dynamics and forecasting in an emerging market economy by incorporating elements from the market microstructure approach. The investigation finds that in the Dominican Republic imbalances between purchases and sales in the foreign exchange market are significant in explaining exchange rate dynamics over and above traditional purchasing power parity (PPP) fundamentals. The investigation runs a forecasting competition, and the preferred model beats a battery of competitors at the 3-month horizon. But an uncovered interest parity (UIP) specification outperforms the otherwise preferred model, a PPP benchmark and a first-order autoregression over 6- and 12-month forecast horizons.

Keywords:

• exchange rate dynamics
• microstructure approach
• PPP
• UIP
• forecasting
• Dominican Republic

JEL classification:

• F31
• F41

Acknowledgements

I thank an anonymous referee, Ashima Goyal (Editor), Alan Carruth, Vince Daly, Zhiyong Li, Amelia U. Santos-Paulino and Chris Stewart for comments and suggestions on previous versions of this article. Any remaining errors are my own.

Notes

1. Some authors explore the relevance of the microstructure approach for other emerging market economies but, to the best of the author’s knowledge, none specifically focus on the intersection between macro-fundamentals and microstructure models. See, for example, Scalia (2008), Melvin, Menkhoff, and Schmeling (2009) and De Roure, Furnagiev, and Reitz (2013).

2. Autometrics employs algorithms based on the general to specific econometric model reduction strategy (Doornik 2009).

Additional information

Funding

This research was partly supported by a Santander Research Mobility grant awarded via Kingston University London.

Notes on contributors

José R. Sánchez-Fung

José R. Sánchez-Fung is a member of the Economics faculty in the University of Nottingham Business School, Ningbo, China. He holds a PhD in Economics from the University of Kent in the UK.