The Out-of-Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond

Richard Clarida, Lucio Sarno (), Mark P. Taylor () and Giorgio Valente ()

No 3281, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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; non-linearity; term structure (search for similar items in EconPapers)
JEL-codes: F31 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk, nep-ifn and nep-rmg
Date: Written
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Related works:
Working Paper: The Out-of-Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond (2001)
Journal Article: The out-of-sample success of term structure models as exchange rate predictors: a step beyond (2003)
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