Direct and Indirect Forecasting of Cross Exchange Rates

The objective of this paper is to determine whether direct forecasting is more or less accurate than indirect forecasting when applied to the cross exchange rate as a defined variable. By using the flexible price monetary model to represent three cross rates, the results show that indirect forecasting is better than direct forecasting, when forecasting accuracy is measured in terms of the root mean square error (RMSE), for two of the three cross rates examined while the opposite is true for the third rate. However, no difference is apparent when performance is measured in terms of directional accuracy. It is concluded that the choice between direct and indirect forecasting is an empirical issue and that the results of such an exercise are case-specific.