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Can long-horizon forecasts beat the random walk under the Engel-West explanation?

Author

Listed:
  • Charles Engel
  • Jian Wang
  • Jason J. Wu

Abstract

Engel and West (EW, 2005) argue that as the discount factor gets closer to one, present-value asset pricing models place greater weight on future fundamentals. Consequently, current fundamentals have very weak forecasting power and exchange rates appear to follow approximately a random walk. We connect the Engel-West explanation to the studies of exchange rates with long-horizon regressions. We find that under EW's assumption that fundamentals are I(1) and observable to the econometrician, long-horizon regressions generally do not have significant forecasting power. However, when EW's assumptions are violated in a particular way, our analytical results show that there can be substantial power improvements for long-horizon regressions, even if the power of the corresponding short-horizon regression is low. We simulate population R squared for long-horizon regressions in the latter setting, using Monetary and Taylor Rule models of exchange rates calibrated to the data. Simulations show that long-horizon regression can have substantial forecasting power for exchange rates.

Suggested Citation

  • Charles Engel & Jian Wang & Jason J. Wu, 2009. "Can long-horizon forecasts beat the random walk under the Engel-West explanation?," Globalization and Monetary Policy Institute Working Paper 36, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddgw:36
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    File URL: http://dallasfed.org/assets/documents/institute/wpapers/2009/0036.pdf
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    Cited by:

    1. Beckmann, Joscha & Czudaj, Robert, 2017. "The impact of uncertainty on professional exchange rate forecasts," Journal of International Money and Finance, Elsevier, vol. 73(PB), pages 296-316.
    2. Jian Wang & Jason J. Wu, 2012. "The Taylor Rule and Forecast Intervals for Exchange Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(1), pages 103-144, February.
    3. repec:eee:reveco:v:56:y:2018:i:c:p:267-287 is not listed on IDEAS
    4. Chen, Shiu-Sheng & Chou, Yu-Hsi, 2015. "Revisiting the relationship between exchange rates and fundamentals," Journal of Macroeconomics, Elsevier, vol. 46(C), pages 1-22.

    More about this item

    Keywords

    Foreign exchange rates ; Financial markets ; Asset pricing ; Forecasting ; Random walks (Mathematics) ; Regression analysis;

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