Non Linear Error Correction in Spot and Forward Exchange Rates

David McMillan and Angela Black

CRIEFF Discussion Papers from Centre for Research into Industry, Enterprise, Finance and the Firm

Abstract: Recent research has increasingly suggested that exchange rates may be characterised by non-linear behaviour which results from the existence of market frictions. This paper examines whether such non-linear behaviour is evident, not in rates themselves, but in the adjustment of rates back to some fundamental equilibrium. Thus, we examine a series of six spot and forward exchange rates to see whether a non-linear error-correction model, which exhibits asymmetric adjustment back to equilibrium either in terms of the size of the deviation from equilibrium or the sign of the deviation outperforms either a random walk model for rates or a linear error-correction model. Our in-sample results suggest that the non-linear models outperform both the linear models, with evidence of significant sign and size threshold effects. Out-of-sample forecasts lend further support for the non-linear models.

Keywords: Non-Linear Error-Correction; Forecasting; Spot and Forward Exchange Rates (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Date: 2001-02
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Journal Article: Nonlinear error correction in spot and forward exchange rates (2001)
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Persistent link: https://EconPapers.repec.org/RePEc:san:crieff:0103

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