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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.

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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    References listed on IDEAS

    as
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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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