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

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  • 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.

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File URL: http://128.118.178.162/eps/data/papers/0503/0503001.zip
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Bibliographic Info

Paper provided by EconWPA in its series Data with number 0503001.

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Date of creation: 19 Mar 2005
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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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Keywords: forecasting; exchange rates; parameter instability; random walks;

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  1. 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.
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  16. Rossi, Barbara, 2002. "Optimal Tests for Nested Model Selection with Underlying Parameter Instability," Working Papers 02-05, Duke University, Department of Economics.
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  21. repec:att:wimass:9417 is not listed on IDEAS
  22. Valentina Corradi & Norman Swanson, 2003. "Some Recent Developments in Predictive Accuracy Testing With Nested Models and (Generic) Nonlinear Alternatives," Departmental Working Papers 200316, Rutgers University, Department of Economics.
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