Practice-Oriented Model Selection in Forex Market

Foreign exchange (FOREX) is required for transactions on current account (goods and services) and capital account (financial assets). In FOREX market, exchange rate is the key variable linking all prices in different countries. Traditionally, it is assumed that exchange rate is determined fundamentally by current account transactions in a long-term perspective (PPP) and by capital account transactions in a short-term perspective (UIP and CIP). As the widespread removal of capital controls, the capital account transactions become the main determinant for the exchange rate. Econometric techniques are usually used as the model comparison criterion, such as likelihood ratio test or Bayes factor. However, these techniques rely on the validity and availability of structured and continuous data measuring the variables in the model. If not, these techniques are not applicable. Moreover, these econometric techniques are only comparing models with models, rather than comparing models with data directly. After all, one can only conclude which model is more relatively true than others, rather than in an absolute sense. Some recent econometric literature attempts to directly confront models with data using Indirect Inference [1,2], but again the selection criterion depends on the choice of auxiliary model through which the model features and the data features are compared. Seeing the limitation of econometric criterion in model selection, this paper proposes a new criterion with less ambition. We are not trying to find the “true” model. Rather, we are looking for the most useful model—the practice-oriented criterion—to generate the highest return in investment practice.