Why is it so difficult to beat the random walk forecast of exchange rates?
Kilian, Lutz and Taylor, Mark P. (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)) (No.302).
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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|
|Official Date:||October 2001|
|Number of Pages:||42|
|Institution:||University of Warwick|
|Status:||Not Peer Reviewed|
|Access rights to Published version:||Open Access|
Abuaf, N. and P. Jorion (1990), “Purchasing Power Parity in the Long Run,” Journal of Finance,
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