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

39 Pages Posted: 17 Nov 2001 Last revised: 24 Oct 2010

See all articles by Richard Clarida

Richard Clarida

Columbia University - Graduate School of Arts and Sciences - Department of Eco; National Bureau of Economic Research (NBER)

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School; Centre for Economic Policy Research (CEPR)

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2001

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.

Suggested Citation

Clarida, Richard H. and Sarno, Lucio and Taylor, Mark Peter and Valente, Giorgio, The Out-of-Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond (November 2001). NBER Working Paper No. w8601. Available at SSRN: https://ssrn.com/abstract=291276

Richard H. Clarida (Contact Author)

Columbia University - Graduate School of Arts and Sciences - Department of Eco ( email )

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National Bureau of Economic Research (NBER)

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Lucio Sarno

City University London - Sir John Cass Business School ( email )

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Centre for Economic Policy Research (CEPR)

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Mark Peter Taylor

Washington University in St. Louis - John M. Olin Business School ( email )

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Centre for Economic Policy Research (CEPR)

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United Kingdom

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR) ( email )

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88 Queensway
Hong Kong
China

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