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Nonlinear exchange rate predictability

  • López-Suárez, Carlos Felipe
  • Rodríguez-López, José Antonio

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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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 30 (2011)
Issue (Month): 5 (September)
Pages: 877-895

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Handle: RePEc:eee:jimfin:v:30:y:2011:i:5:p:877-895
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