Why is it so difficult to outperform the random walk in exchange rate forecasting?

Imad Moosa

Applied Economics, 2013, vol. 45, issue 23, 3340-3346

Abstract: A simulation exercise is used to demonstrate the difficulty to outperform the random walk in exchange rate forecasting if forecasting accuracy is judged by the Root Mean Square Error (RMSE) or similar criteria that depend on the magnitude of the forecasting error. It is shown that, as the exchange rate volatility rises, the RMSE of the model rises faster than that of the random walk. While the literature considers this finding to be a puzzle that casts a big shadow of doubt on the soundness of international monetary economics, the results show that failure to outperform the random walk, in both in-sample and out-of-sample forecasting, should be the rule rather than the exception. However, the results do not imply that the random walk is unbeatable, because it can be easily outperformed if forecasting accuracy is judged according to criteria such as direction accuracy and profitability.

Date: 2013
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Citations: View citations in EconPapers (19)

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DOI: 10.1080/00036846.2012.709605

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