Research Discussion Papers, Bank of Finland
Biing-Shen Kuo and Anne Mikkola
Forecasting the Real US/DEM Exchange Rate: TAR vs. AR
Abstract: The out-of-sample forecasting performances of two
univariate time series presentations for the USD/DEM real exchange rate are
compared using quarterly data for the period 1957Q1-1998Q4. The linear AR
process is frequently fitted to real exchange rate series because it is
sufficient for capturing the reported slow mean reversion in real exchange
rates and it has some predictive ability for the long run. A simple
nonlinear alternative, the threshold autoregressive (TAR) model, allows for
the possibility that there is a band of slow or no convergence around the
purchasing power parity level in the real exchange rate, due to
transportation costs or other market frictions that create barriers to
arbitrage. The TAR model is theoretically and empirically appealing, and it
has been fitted to real exchange rates in many recent papers. However, the
ultimate test of its usefulness is its out-of-sample forecasting accuracy.
We compare the TAR model to its simple linear AR alternative in terms of
out-of-sample forecast accuracy. Preliminary results using the RMSE
criterion indicate that TAR forecasts are more sensitive to the estimation
period and that they involve considerably more uncertainty at long
horizons, as compared with the simple AR model.
Keywords: real exchange rate; TAR model; forecast accuracy; (follow links to similar papers)
21 pages, October 3, 2000
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