Forecasting the Yen/U.S. Dollar Exchange Rate: Empirical Evidence from a Capital Enhanced PPP-Based Model

This study uses a relative purchasing power parity (PPP) model based on price indexes (consumer, CPI or traded-goods price indexes, TPI), interest rate differentials, and a linear forecasting technique to determine the horizon over which such a model outperforms a random walk in forecasting the Yen/U.S. Dollar exchange rates out-of-sample. The results improve if one adjusts a simple CPI-based PPP-model by interest rate differentials, while the best results are obtained using a TPI-based PPP-model. For example, the TPI-based model, adjusted by interest rate differentials, is able to statistically significantly outperform the pure random walk starting at forecast horizons of 1 month.