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

40 Pages Posted: 23 Apr 2002

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 Monetary Authority - Hong Kong Institute for Monetary Research (HKIMR)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2002

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. There is evidence, however, that the term structure of forward premia contains valuable information for forecasting future spot exchange rates and that exchange rate dynamics display non-linearities. 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, to a lesser extent, a linear term-structure vector equilibrium correction model for four major dollar rates across a range of horizons.

Keywords: Foreign exchange, term structure, forecasting, non-linearity, Markov switching

JEL Classification: F31

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 (March 2002). CEPR Discussion Paper No. 3281. Available at SSRN: https://ssrn.com/abstract=308586

Richard H. Clarida (Contact Author)

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

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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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Giorgio Valente

Hong Kong Monetary Authority - Hong Kong Institute for Monetary Research (HKIMR) ( email )

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Hong Kong
China

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