Forecasting Emerging Markets Currencies with Financial Data

Belonged to the third framework of factor modeling: factors and their exposures are latent, this paper uses financial variables to simulate and forecast short-run emerging markets (EM) exchange rates and provide empirical investment strategies with sound back-test returns. We first conduct moving window PCA to construct dynamic factors from financial variables, then use a sample OLS mode for high-frequency data with short rolling windows and an Error Correction model for low-frequency data with long rolling windows. In this paper, we show that the asset returns of EM equity and EM bonds both have a significant impact on EM currencies. We also show there is a long-run equilibrium correlation between EM currencies and major financial market prices.

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