Skip to main content
×
×
Home

ARE EXCHANGE RATES REALLY RANDOM WALKS? SOME EVIDENCE ROBUST TO PARAMETER INSTABILITY

  • BARBARA ROSSI (a1)
Abstract

Many authors have documented that it is challenging to explain exchange rate fluctuations with macroeconomic fundamentals: a random walk forecasts future exchange rates better than existing macroeconomic models. This paper applies newly developed tests for nested models that are robust to the presence of parameter instability. The empirical evidence shows that for some countries we can reject the hypothesis that exchange rates are random walks. This raises the possibility that economic models were previously rejected not because the fundamentals are completely unrelated to exchange rate fluctuations, but because the relationship is unstable over time and, thus, difficult to capture by Granger causality tests or by forecast comparisons. We also analyze forecasts that exploit the time variation in the parameters and find that, in some cases, they can improve over the random walk.

Copyright
Corresponding author
Address correspondence to: Barbara Rossi, Department of Economics, Duke University, Durham, NC 27708, USA; e-mail: brossi@econ.duke.edu.
References
Hide All
Andrews Donald W.K. 1993 Tests for parameter instability and structural change with unknown change point. Econometrica 61, 821856.
Andrews Donald W.K. and W. Ploberger 1994 Optimal tests when a nuisance parameter is present only under the alternative. Econometrica 62, 13831414.
Chao John C., Valentina Corradi, and Norman Swanson 2001 An out of sample test for Granger causality. Macroeconomic Dynamics 5, 598620.
Clark Todd E. and Michael W. McCracken 2001 Tests of equal forecast accuracy and encompassing for nested models. Journal of Econometrics 105, 85110.
Clark Todd E. and Michael W. McCracken 2005 The power of tests of predictive ability in the presence of structural breaks. Journal of Econometrics 124, 131.
Corradi Valentina and Norman Swanson 2004 Some recent developments in predictive accuracy testing with nested models and (generic) nonlinear alternatives. International Journal of Fore- casting 20, 185199.
Corradi Valentina and Norman Swanson 2005 Bootstrap conditional distribution tests under dynamic misspecification. Journal of Econometrics 124, 117148.
Diebold Francis X. and Roberto S. Mariano 1995 Comparing predictive accuracy. Journal of Business and Economic Statistics 13, 253263.
Elliott Graham 2005 Forecasting When There Is a Single Break Mimeo, University of California, San Diego.
Engel Charles 1994 Can the Markov switching model forecast exchange rates? Journal of International Economics 36, 151165.
Frankel Jeffrey A. and Andrew K. Rose 1995 Empirical research on nominal exchange rates. In G. Grossman and K. Rogoff (eds.), Handbook of International Economics, vol. III. Amsterdam: Elsevier–North Holland.
Inoue Atsushi and Lutz Kilian 2002 On the Selection of Forecasting Models. Mimeo, European Central Bank.
Marsh Ian 2000 High-frequency Markov switching models in the foreign exchange market. Journal of Forecasting 19, 123134.
McCracken Michael 1999 Asymptotics for Out-of-Sample Tests of Causality. Mimeo, Louisiana State University.
Meese Richard A. 1990 Currency fluctuations in the post-Bretton Woods era. Journal of Economic Perspectives 4, 117134.
Meese Richard A. and Kenneth Rogoff 1983a Empirical exchange rate models of the seventies: Do they fit out-of-sample? Journal of International Economics 14, 324.
Meese Richard A. and Kenneth Rogoff 1983b The out-of-sample failure of empirical exchange rate models: Sampling error or mis-specification?. In J. Frenkel (ed.), Exchange Rates and International Macroeconomics, pp. 67105. Chicago: University of Chicago Press.
Meese Richard A. and Kenneth Rogoff 1988 Was it real? The exchange rate–interest differential relation over the modern floating period. Journal of Finance 43, 923948.
Nyblom Jukka 1989 Testing for the constancy of parameters over time. Journal of the American Statistical Association 84, 223230.
Quandt Richard E. 1960 Tests of the hypothesis that a linear regression system obeys two separate regimes. Journal of the American Statistical Association 55, 324330.
Rossi Barbara 2005 Optimal tests for nested model selection with underlying parameter instability. Econometric Theory 21, 962990.
Schinasi Garry and P.A.V.B. Swamy 1989 The out-of-sample forecasting performance of exchange rate models when coefficients are allowed to change. Journal of International Money and Finance 8, 375390.
Stock James H. and Mark W. Watson 1996 Evidence on structural instability in macroeconomic time series relations. Journal of Business and Economic Statistics 14, 1130.
Stock James H. and Mark W. Watson 1998 Median unbiased estimation of coefficient variance in a time-varying parameter model. Journal of the American Statistical Association 93, 349358.
Stock James H. and Mark W. Watson 1999 Business cycle fluctuations in U.S. macroeconomic time series. In John Taylor and Michael Woodford (eds.), Handbook of Macroeconomics, vol. I, pp. 364. A. Amsterdam: North-Holland.
Stock James H. and M. Wark Watson 2003 Forecasting output and inflation: The role of asset prices. Journal of Economic Literature 41, 788829.
Timmermann Allan (in press) Forecast combinations. In G. Elliott, C.W.J. Granger, and A. Timmermann (eds.), Handbook of Economic Forecasting. Amsterdam: North-Holland.
West Kenneth 1996 Asymptotic inference about predictive ability. Econometrica 64, 10671084.
Wolff Christian 1987 Time-varying parameters and out-of-sample forecasting performance of structural exchange rate models. Journal of Business and Economic Statistics 5, 8797.
Wright Jonathan 2004 Bayesian Model Averaging and Exchange Rate Forecasts. Federal Reserve Board International Finance Discussion Paper No. 779.
Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
  • URL: /core/journals/macroeconomic-dynamics
Please enter your name
Please enter a valid email address
Who would you like to send this to? *
×

Keywords

Metrics

Full text views

Total number of HTML views: 0
Total number of PDF views: 0 *
Loading metrics...

Abstract views

Total abstract views: 0 *
Loading metrics...

* Views captured on Cambridge Core between <date>. This data will be updated every 24 hours.

Usage data cannot currently be displayed