Politics and exchange rate forecasts

Standard exchange rate models perform poorly in out-of-sample forecasting when compared to the random walk model. We posit part of the poor performance of these models may be due to omission of political factors. We test this hypothesis by including political variables that capture party-specific, election-specific and candidate-specific characteristics. Surprisingly, we find our political model outperforms the random walk in out-of-sample forecasting at 1-12 month horizons for the pound/dollar, mark/dollar, pound/mark and the trade-weighted dollar, mark and pound exchange rates.