Working Paper: NBER ID: w8601
Authors: Richard H. 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. 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.
Keywords: exchange rates; term structure models; forecasting
JEL Codes: F31; F37
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forward premia (G19) | spot exchange rate forecasts (F31) |
| nonlinear MSVECM (C32) | accuracy of exchange rate predictions (F31) |
| term structure (E43) | exchange rate forecasting (F37) |