Winners and Losers in the Asia-Pacific
Edited by Noel Gaston and Ahmed M. Khalid
Chapter 6: Forecasting International Financial Prices with Fundamentals: How do Stocks and Exchange Rates Compare?
Robert P. Flood and Andrew K. Rose* MOTIVATION We are now in the midst of an era of financial integration, which is leading to convergence of international financial prices. Indeed, international financial flows are largely driven by discrepancies in asset prices across borders. This would be widely seen as a welcome development if asset prices were well grounded in economic fundamentals. Part of what our analysis seeks to do is question this latter assumption, and thus the presumption that financial integration can be automatically viewed as good for economic welfare. The integration of international financial markets is a key part of globalization. Understanding how these markets operate in practice is thus important. In this chapter, we study price determination in international markets for two important assets: stock prices and foreign exchange rates. We ask how our knowledge of foreign exchange markets for developed countries compares with our knowledge of comparable equity markets. More specifically, we are interested in our ability to model and forecast international equity prices and exchange rates. In their now-classic papers (1983a, b), Richard Meese and Kenneth Rogoff (hereafter “MR”) examined the forecasting performance of a number of then-popular exchange rate models. They found that a random walk “model” of the exchange rate consistently outforecast the structural models, despite the latter’s being given the advantage of using actual future values of market fundamentals. The full reaction to the MR message took years to process, but was eventually devastating for the field of international finance. Academic modeling of...
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