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Why is it so difficult to beat the random walk forecast of exchange rates

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Author Info
Lutz Kilian () (University of Michigan at Ann Arbor - Department of Economics, 611 Tappan Street, Ann Arbor , MI 48109-1220, United States.)
Mark P. Taylor () (University of Warwick - Department of Economics, Coventry CV4 7AL, United Kingdom.)

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Abstract

We propose a nonlinear econometric model that can explain both the observed volatility and the persistence of real and nominal exchange rates. The model implies that near equilibrium, the nominal exchange rate will be well approximated by a random walk process. Large departures from fundamentals, in contrast, imply mean-reverting behavior toward fundamentals. Moreover, the predictability of the nominal exchange rate relative to the random walk benchmark tends to improve at longer horizons. We test the implications of the model and find strong evidence of exchange rate predictability at horizons of two to three years, but not at shorter horizons. JEL Classification: F31; F47; C53.

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Paper provided by European Central Bank in its series Working Paper Series with number 088.

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Length: 56 pages
Date of creation: Nov 2001
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Handle: RePEc:ecb:ecbwps:20010088

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Keywords: Purchasing power parity; real exchange rate; random walk; economic models of exchange rate determination; long-horizon regression tests.;

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  32. Mark, Nelson C. & Sul, Donggyu, 2001. "Nominal exchange rates and monetary fundamentals: Evidence from a small post-Bretton woods panel," Journal of International Economics, Elsevier, vol. 53(1), pages 29-52, February. [Downloadable!] (restricted)
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  33. Diebold, Francis X & Mariano, Roberto S, 1995. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(3), pages 253-63, July.
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  34. Lothian, James R & Taylor, Mark P, 1996. "Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 488-509, June. [Downloadable!] (restricted)
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