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Nonlinear Exchange Rate Predictability

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  • Carlos Felipe Lopez Suarez
  • Jose Antonio Rodriguez Lopez

    ()
    (Department of Economics, University of California-Irvine)

Abstract

We study whether the nonlinear behavior of the real exchange rate can help us account for the lack of predictability of the nominal exchange rate. We construct a smooth nonlinear error-correction model that allows us to test the hypotheses of nonlinear predictability of the nominal exchange rate and nonlinear behavior on the real exchange rate in the context of a fully specified cointegrated system. Using a panel of 19 countries and three numeraires, we find evidence of nonlinear predictability of the nominal exchange rate and of nonlinear mean reversion of the real exchange rate. Out-of-sample Theil's U-statistics show a higher forecast precision of the nonlinear model than the one obtained with a random walk specification. Although the robustness of the out-of-sample results over different forecast windows is somewhat limited, we are able to obtain significant predictability gains--from a parsimonious structural model with PPP fundamentals--even at short-run horizons.

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Bibliographic Info

Paper provided by University of California-Irvine, Department of Economics in its series Working Papers with number 080911.

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Length: 30 pages
Date of creation: Dec 2008
Date of revision: Sep 2010
Handle: RePEc:irv:wpaper:080911

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Keywords: Exchange rates; Predictability; Nonlinearities; Purchasing power parity;

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Cited by:
  1. Ca' Zorzi, Michele & Muck, Jakub & Rubaszek, Michał, 2013. "Real exchange rate forecasting: a calibrated half-life PPP model can beat the random walk," Working Paper Series, European Central Bank 1576, European Central Bank.

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