Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?

Lutz Kilian and Mark Taylor

No 464, Working Papers from Research Seminar in International Economics, University of Michigan

Abstract: We propose a stylized exchange rate model based on diversity and weight of opinion. Our model departs from standard assumptions in that we allow for heterogeneous agents. We show that such a model can explain both the observed volatility and the persistence of real and nominal exchange rate movements and thus in some measure resolves Rogoff’s (1996) purchasing power parity puzzle. Our empirical analysis reconciles the well-known difficulties in beating the random walk forecast model with the statistical evidence of nonlinear mean reversion in deviations from fundamentals. We find strong evidence of long-horizon predictability both in theory and in practice. We also explain why it is difficult to exploit this predictability in out-ofsample forecasts. Our results not only lend support to economists’ beliefs that the exchange rate is inherently predictable, but they also help us to understand the reluctance of applied forecasters to abandon chartists methods in favor of models based on economic fundamentals.

Keywords: Purchasing power parity; Real exchange rate; Random walk; Economic models of exchange rate determination; Long-horizon regression tests. (search for similar items in EconPapers)
JEL-codes: C53 F31 F47 (search for similar items in EconPapers)
Pages: 43 Pages
Date: 2001
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (64)

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http://www.fordschool.umich.edu/rsie/workingpapers/Papers451-475/r464.pdf

Related works:
Journal Article: Why is it so difficult to beat the random walk forecast of exchange rates? (2003)
Working Paper: Why is it so Difficult to Beat the Random Walk Forecast of Exchange Rates? (2001)
Working Paper: Why is it so difficult to beat the random walk forecast of exchange rates? (2001)
Working Paper: Why is it so difficult to beat the Random Walk Forecast of Exchange Rates? (2001)
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