Forecasting the USD/COP Exchange Rate: A Random Walk a Variable Drift

This study develops three exchange rate models as well as a simple statistical model defined as a random walk with a variable drift. The exchange rate models all use the purchasing power parity hypothesis to account for the long-term relationships between prices and the exchange rate, together with error correction models to represent any shortterm dynamics. The models are estimated for the USD/COP rate of exchange, and their forecast performance is compared to that of a simple random walk as well as to that of the random walk with a variable drift term.Two of the models are shown to outperform the simple random walk on the 12 and 24 -months forecasting horizont. However, all the models are outperformed by the random walk with a variable drift, where the drift term is estimated using a Kalman filter. The results suggest that fundamnetal modles might only be a useful tool for forecasting of the exchange rate in the very long run.