Exchange rate forecasting on a napkin

•Real exchange rates adjust toward PPP.•The adjustment is driven by nominal exchange rates.•PPP adjustment can be exploited in exchange rate forecasting.•Accounting for nonlinearities does not improve the accuracy of exchange rate forecasts.•We propose a method to forecast exchange rates, which is so simple that it can be applied on the back of a napkin. This paper shows that there are two regularities in foreign exchange markets in advanced countries with flexible regimes. First, real exchange rates are mean-reverting, as implied by the Purchasing Power Parity model. Second, the adjustment takes place via nominal exchange rates. These features of the data can be exploited, even on the back of a napkin, to generate nominal exchange rate forecasts that outperform the random walk. The secret is to avoid estimating the pace of mean reversion and assume that relative prices are unchanged. Direct forecasting, panel data techniques and non-linear models can outperform the random walk, but fail to beat this simple calibrated model.