Forecasting the daily exchange rate of the UK pound sterling against the US dollar

· An economic theory-based model is used to forecast the daily GBP/USD exchange rate. · The 35-year out-of-sample evaluation period is longer than in earlier studies. · Forecasts outperform the random walk for horizons from one day to five years. · The model provides impressive direction-of-change forecasts. · A model-based trading strategy outperforms the carry trade. This paper is the first to use an economic theory-based model—the monetary model of exchange rates within a rational expectations present value framework—to forecast the daily exchange rate of a major currency. Our out-of-sample forecast evaluation period, spanning from 1990 to 2024, is longer than that of any other exchange rate forecasting study. We find that our model's forecasts outperform the random walk across all forecasting horizons, ranging from one day to five years. Moreover, a trading strategy based on our model's forecasts yields economically and statistically significant excess returns, surpassing those of the carry trade strategy.