Kilian, Lutz and Taylor, Mark P., 1958- (2001) Why is it so difficult to beat the random walk forecast of exchange rates? Discussion Paper. London: Centre for Economic Policy Research (Great Britain). (Discussion paper (Centre for Economic Policy Research (Great Britain)).

Preview

PDF WRAP_Taylor_CEPR-DP3024[2].pdf - Requires a PDF viewer such as GSview, Xpdf or Adobe Acrobat Reader Download (156Kb)

Abstract

We propose an exchange rate model that can explain both the observed volatility and the persistence of real and nominal exchange rate movements and thus in some measure resolves Rogoff’s (1996) purchasing power parity puzzle. Our analysis reconciles the well-known difficulties in beating the random walk forecast model with the statistical evidence of nonlinear mean reversion in deviations from fundamentals. Our analysis also provides a compelling rationale for the long-horizon predictability of exchange rates. We find strong empirical support for long-horizon predictability, and we explain why it is difficult to exploit this predictability in real-time forecasts. Our results not only lend support to economists’ beliefs that the exchange rate is inherently predictable, but they also help us to understand the reluctance of applied forecasters to abandon chartist methods in favor of models based on economic fundamentals.

Item Type:	Working or Discussion Paper (Discussion Paper)
Subjects:	H Social Sciences > HB Economic Theory
Divisions:	Faculty of Social Sciences > Economics
Library of Congress Subject Headings (LCSH):	Foreign exchange rates -- Econometric models, Regression analysis -- Mathematical models, Purchasing power parity, Random walks (Mathematics)
Series Name:	Discussion paper (Centre for Economic Policy Research (Great Britain))
Publisher:	Centre for Economic Policy Research (Great Britain)
Place of Publication:	London
Date:	October 2001
Number:	No.302
Number of Pages:	42
Status:	Not Peer Reviewed
Access rights to Published version:	Open Access
References:	Abuaf, N. and P. Jorion (1990), “Purchasing Power Parity in the Long Run,” Journal of Finance, 45, 157-174. Allen, H. and M.P. Taylor (1990), “Charts, Noise and Fundamentals in the Foreign Exchange Market,” Economic Journal, 100, 49-59. Allen, H. and M.P. Taylor (1992), “Chartist Analysis,” in M. Milgate, P. Newman and J. Eatwell (eds.), The New Palgrave Dictionary of Money and Finance, London: MacMillan. Andrews, D.W.K. (1991), “Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation,” Econometrica, 59, 817-858. Balke, N.S., and T.B. Fomby (1997), “Threshold Cointegration,” International Economic Review, 38, 627-645. Berben R.-P., and D. van Dijk (1998), “Does the Absence of Cointegration Explain the Typical Findings in Long-Horizon Regressions?”, mimeo, Tinbergen Institute, Erasmus University Rotterdam. Berkowitz, J., and L. Giorgianni (2001), “Long-Horizon Exchange Rate Predictability?” Review of Economics and Statistics, 83, 81-91. Cheung, Y.-W., and M.D. Chinn (1999), “Macroeconomic Implications of the Beliefs and Behavior of Foreign Exchange Traders,” NBER Working Paper No. 7417. Chinn, M.D., and R.A. Meese (1995), “Banking on Currency Forecasts: How Predictable is Change in Money?” Journal of International Economics, 38, 161-178. De Grauwe, P., and H. Dewachter (1993), “A Chaotic Model of the Exchange Rate: The Role of Fundamentalists and Chartists,” Open Economies Review, 4, 351-379. De Long, J.B., A. Shleifer, L.H. Summers, and R.J. Waldmann (1990a), “Noise Trader Risk in Financial Markets,” Journal of Political Economy, 98, 703-738. De Long, J.B., A. Shleifer, L.H. Summers, and R.J. Waldmann (1990b), “Positive Feedback Investment Strategies and Destabilizing Rational Speculation,” Journal of Finance, 45, 379-395. Diebold, F.X., and R. Mariano (1995), “Comparing Predictive Accuracy,” Journal of Business and Economic Statistics, 13, 253-262. Dumas, B., (1992), “Dynamic Equilibrium and the Real Exchange Rate in Spatially Separated Worlds,” Review of Financial Studies, 5, 153-180. Eitrheim, O. and T. Teräsvirta (1996), “Testing the Adequacy of Smooth Transition Autoregressive Models,” Journal of Econometrics, 74, 59-75. Frankel, J.A., and K.A. Froot (1990), “Chartists, Fundamentalists and the Demand for Dollars,” in A.S. Courakis and M.P. Taylor (eds.), Private Behaviour and Government Policies in Interdependent Economies, Oxford: Oxford University Press, 73-126. Frenkel, J. (1976), “A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence,” Scandinavian Journal of Economics, 78, 200-224. Gallant, A.R. (1987), Nonlinear Statistical Models, New York: Wiley. Gallant, A.R. and H. White (1988), A Unified Theory of Estimation and Inference for Nonlinear Dynamic Models, Oxford: Oxford University Press. Granger, C.W.J., and T. Teräsvirta (1993), Modelling Nonlinear Economic Relationships, Oxford: Oxford University Press. Hegwood, N.D. and D.H. Papell (1998), “Quasi Purchasing Power Parity,” International Journal of Finance and Economics, 3, 279-289. Kilian, L. (1999), “Exchange Rates and Monetary Fundamentals: What Do We Learn from Long-Horizon Regressions?” Journal of Applied Econometrics, 14, 491-510. Klimko, L.A., and P.I. Nelson (1978), “On Conditional Least Squares Estimation for Stochastic Processes,” Annals of Statistics, 6, 629-42. Lothian, J.R. and M.P. Taylor (1996), “Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries,” Journal of Political Economy, 104, 488-510. Lothian, J.R. and M.P. Taylor (1997), “Real Exchange Rate Behavior: The Problem of Power and Sample Size,” Journal of International Money and Finance, 16, 945-954. Mark, N.C. (1995), “Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability,” American Economic Review, 85, 201-218. Mark, N.C., and D. Sul (2001), “Nominal Exchange Rates and Monetary Fundamentals: Evidence from a Small Bretton Woods Panel,” Journal of International Economics, 53, 29-52. McCracken, M.W. (1999), “Asymptotics for Out-of-Sample Tests of Causality,” manuscript, Department of Economics, Lousiana State University. Meese, R. and K. Rogoff (1983a), “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics, 14, 3-24. Meese, R. and K. Rogoff (1983b), “The Out-of-.Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?” in J.A. Frenkel (ed.) Exchange Rates and International Macroeconomics, Chicago: Chicago University Press and National Bureau of Economic Research. Rogoff, K. “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, 34, 647-668. Sarno, L. and M.P. Taylor (2001), “Deviations of Exchange Rates from Purchasing Power Parity: A Cautionary Note,” forthcoming: International Monetary Fund Staff Papers. Shleifer, A., and L. Summer (1990), “The Noise Trader Approach to Finance,” Journal of Economic Perspectives, 4, 19-33. Taylor, M.P. (1995), “The Economics of Exchange Rates,” Journal of Economic Literature, 33,. 13-47. Taylor, M.P., and H. Allen (1992), “The Use of Technical Analysis in the Foreign Exchange Market,” Journal of International Money and Finance, 11, 304-314. Taylor, M.P. and P.C. McMahon (1998), “Long-Run Purchasing Parity in the 1920s,” European Economic Review, 32, 179-197. Taylor, M.P., and D.A. Peel (2000), “Nonlinear Adjustment, Long Run Equilibrium and Exchange Rate Fundamentals,” Journal of International Money and Finance, 19, 33-53. Taylor, M.P., D.A. Peel and L. Sarno (2001), “Nonlinear Adjustment in Real Exchange Rates: Towards a Solution to the Purchasing Power Parity Puzzles,” forthcoming: International Economic Review. Taylor, M.P. and L. Sarno, (1998), “The Behavior of Real Exchange Rates During the Post Bretton Woods Period,” Journal of International Economics, 46, 281-312. Teräsvirta, T. (1994), “Specification, Estimation and Evaluation of Smooth Transition Autoregressive Models,” Journal of the American Statistical Association, 89, 208-218. Tjøstheim, D. (1986), “Estimation in Nonlinear Time Series Models,” Stochastic Processes and Their Applications, 21, 251-73.
URI:	http://wrap.warwick.ac.uk/id/eprint/1684

Request changes to a record

Actions (login required)

View Item