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Why is it so difficult to beat the random walk forecast of exchange rates?
Authors:Lutz Kilian  Mark P Taylor
Institution:a Department of Economics, University of Michigan, Ann Arbor, MI 48109-1220, USA
b Department of Economics, University of Warwick, Coventry CV4 7AL, UK
c Centre for Economic Policy Research, London, UK
d European Central Bank, 60311 Frankfurt a.M., Germany
Abstract:Recent empirical evidence suggests that the time series behavior of the real exchange rate is well approximated by a nonlinear, exponential smooth transition autoregressive (ESTAR) model. This nonlinearity helps resolve a number of puzzles concerning the persistence and volatility of real exchange rates. In this paper, we explore whether it may also help resolve the well-known difficulties of exchange rate forecasting. We develop a bootstrap test of the random walk hypothesis of the nominal exchange rate, given ESTAR real exchange rate dynamics. We find strong evidence of predictability at horizons of 2 to 3 years, but not at shorter horizons.
Keywords:Purchasing power parity  Real exchange rate  Random walk  Economic models of exchange rate determination  Long-horizon regression tests
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