Forecasting fuel prices with the Chilean exchange rate: Going beyond the commodity currency hypothesis

In this paper we show that the Chilean exchange rate has the ability to predict the returns of oil and of three additional oil-related products: gasoline, propane and heating oil. We show this using both in- and out-of sample exercises at multiple horizons. Natural explanations for our findings rely on the well know “dollar effect” and on the present-value theory for exchange rate determination in combination with the strong co-movement displayed by fuel and metal prices. Given that the Chilean economy is heavily influenced by copper, which represents nearly 50% of total national exports, the floating Chilean Peso is importantly affected by price fluctuations in this metal. As oil-related products display an important co-movement with base metal prices, it is reasonable to expect evidence of Granger causality from the Chilean peso to these oil-related products. Interestingly, we provide sound evidence indicating that the predictive ability of the Chilean Peso goes beyond these natural explanations. In particular, we show another plausible predictive channel: volatility in combination with a negative contemporaneous leverage effect in fuel returns. Finally, we compare the Chilean peso with other commodity-currencies in their ability to predict fuel returns. The Chilean peso fares extremely well in this competition, especially at short horizons of one, three and six months.