Exchange rate return predictability in times of geopolitical risk

We develop the hypothesis that geopolitical risk predicts exchange rate returns. Using data on 17 countries, we demonstrate that the information content embedded in geopolitical risk is economically useful and can improve the forecast accuracy of exchange rate returns. We show that geopolitical risk predicts 10 out of 17 (59%) exchange rate returns in in-sample tests while in out-of-sample tests predictability is found for 88% of currencies. Buy and sell signals generated from our model lead to higher returns compared to the historical average model. Our model delivers excess profits relative to the benchmark model in 11 out of 17 (65%) currencies.

Automated summary

Geopolitical risk predicts exchange rate returns and improves forecast accuracy, demonstrating economic usefulness. Testing on 17 countries, 59% of exchange rate returns are predicted in-sample and 88% out-of-sample. Our model generates buy/sell signals that outperform the historical average model, resulting in excess profits in 65% of currencies.