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Are Exchange Rates Really Random Walks? Some Evidence Robust to Parameter Instability

Author

Listed:
  • Barbara Rossi

    (Duke University)

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 model 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.

Suggested Citation

  • Barbara Rossi, 2005. "Are Exchange Rates Really Random Walks? Some Evidence Robust to Parameter Instability," Data 0503001, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpda:0503001
    Note: Type of Document - zip. The zip file contains two directories, each of which contains files to replicate the results in the two distinct sections of the paper (sections 4 and 5). The data are in .txt format, and the codes are in Matlab. Both directories contain a readme file.
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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/data/papers/0503/0503001.zip
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    References listed on IDEAS

    as
    1. Rossi, Barbara, 2005. "Optimal Tests For Nested Model Selection With Underlying Parameter Instability," Econometric Theory, Cambridge University Press, vol. 21(5), pages 962-990, October.
    2. Richard Meese & Kenneth Rogoff, 1983. "The Out-of-Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 67-112, National Bureau of Economic Research, Inc.
    3. Engel, Charles, 1994. "Can the Markov switching model forecast exchange rates?," Journal of International Economics, Elsevier, vol. 36(1-2), pages 151-165, February.
    4. Clark, Todd E. & McCracken, Michael W., 2001. "Tests of equal forecast accuracy and encompassing for nested models," Journal of Econometrics, Elsevier, vol. 105(1), pages 85-110, November.
    5. West, Kenneth D, 1996. "Asymptotic Inference about Predictive Ability," Econometrica, Econometric Society, vol. 64(5), pages 1067-1084, September.
    6. Corradi, Valentina & Swanson, Norman R., 2006. "Bootstrap conditional distribution tests in the presence of dynamic misspecification," Journal of Econometrics, Elsevier, vol. 133(2), pages 779-806, August.
    7. Corradi, Valentina & Swanson, Norman R., 2004. "Some recent developments in predictive accuracy testing with nested models and (generic) nonlinear alternatives," International Journal of Forecasting, Elsevier, vol. 20(2), pages 185-199.
    8. Meese, Richard, 1990. "Currency Fluctuations in the Post-Bretton Woods Era," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 117-134, Winter.
    9. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-144, January.
    10. Graham Elliott & Allan Timmermann, 2016. "Economic Forecasting," Economics Books, Princeton University Press, edition 1, number 10740.
    11. Timmermann, Allan, 2006. "Forecast Combinations," Handbook of Economic Forecasting, in: G. Elliott & C. Granger & A. Timmermann (ed.), Handbook of Economic Forecasting, edition 1, volume 1, chapter 4, pages 135-196, Elsevier.
    12. Andrews, Donald W K, 1993. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Econometrica, Econometric Society, vol. 61(4), pages 821-856, July.
    13. James H. Stock & Mark W.Watson, 2003. "Forecasting Output and Inflation: The Role of Asset Prices," Journal of Economic Literature, American Economic Association, vol. 41(3), pages 788-829, September.
    14. Clark, Todd E. & McCracken, Michael W., 2005. "The power of tests of predictive ability in the presence of structural breaks," Journal of Econometrics, Elsevier, vol. 124(1), pages 1-31, January.
    15. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
    16. Chao, John & Corradi, Valentina & Swanson, Norman R., 2001. "Out-Of-Sample Tests For Granger Causality," Macroeconomic Dynamics, Cambridge University Press, vol. 5(4), pages 598-620, September.
    17. Stock, James H. & Watson, Mark W., 1999. "Business cycle fluctuations in us macroeconomic time series," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 1, pages 3-64, Elsevier.
    18. Schinasi, Garry J. & Swamy, P. A. V. B., 1989. "The out-of-sample forecasting performance of exchange rate models when coefficients are allowed to change," Journal of International Money and Finance, Elsevier, vol. 8(3), pages 375-390, September.
    19. Frankel, Jeffrey A. & Rose, Andrew K., 1995. "Empirical research on nominal exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 33, pages 1689-1729, Elsevier.
    20. Inoue, Atsushi & Kilian, Lutz, 2006. "On the selection of forecasting models," Journal of Econometrics, Elsevier, vol. 130(2), pages 273-306, February.
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    24. McCracken, Michael W., 2007. "Asymptotics for out of sample tests of Granger causality," Journal of Econometrics, Elsevier, vol. 140(2), pages 719-752, October.
    25. Wolff, Christian C P, 1987. "Time-Varying Parameters and the Out-of-Sample Forecasting Performance of Structural Exchange Rate Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 5(1), pages 87-97, January.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    forecasting; exchange rates; parameter instability; random walks;
    All these keywords.

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • F3 - International Economics - - International Finance

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