Why is it so Difficult to Beat the Random Walk Rorecast of Exchange Rates?

56 Pages Posted: 27 Feb 2003

See all articles by Lutz Kilian

Lutz Kilian

University of Michigan at Ann Arbor - Department of Economics; 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)

Date Written: November 2001

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.

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

JEL Classification: F31, F47, C53

Suggested Citation

Kilian, Lutz and Taylor, Mark Peter, Why is it so Difficult to Beat the Random Walk Rorecast of Exchange Rates? (November 2001). ECB Working Paper No. 88. Available at SSRN: https://ssrn.com/abstract=356266

Lutz Kilian (Contact Author)

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-764-2320 (Phone)
734-764-2769 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Mark Peter Taylor

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

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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