Working Paper: CEPR ID: DP3281
Authors: Richard Clarida; Lucio Sarno; Mark P. 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. 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: forecasting; foreign exchange; Markov switching; nonlinearity; term structure
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| MS-VECM structure (C32) | forecasting performance (C53) |
| MS-VECM (C32) | outperforms random walk model (C52) |
| MS-VECM (C32) | outperforms linear VECM (C22) |
| nonlinearities in term structure (E43) | exchange rate dynamics (F31) |