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The Out-of-Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond

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  • Richard Clarida
  • Lucio Sarno
  • Mark Taylor
  • Giorgio Valente

Abstract

A large literature suggests that standard exchange rate models cannot outperform a random walk forecast and that the forward rate is not an optimal predictor of the spot rate. However, there is evidence that the term structure of forward premia contains valuable information for forecasting future spot exchange rates and that exchange rate dynamics display nonlinearities. This paper proposes a term-structure forecasting model of exchange rates based on a regime-switching vector equilibrium correction model which is novel in this context. Our model significantly outperforms both a random walk and a linear term-structure vector equilibrium correction model for four major dollar rates across a range of horizons.

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  • Richard Clarida & Lucio Sarno & Mark Taylor & Giorgio Valente, 2001. "The Out-of-Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond," NBER Working Papers 8601, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:8601
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    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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