Scandinavian Working Papers in Economics

Working Paper Series,
Trade Union Institute for Economic Research

No 175: How to Beat the Random Walk

Annika Alexius
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Annika Alexius: Trade Union Institute for Economic Research, Postal: FIEF, Wallingatan 38, SE-111 24 Stockholm, Sweden

Abstract: Out-of-sample forecasting accuracy is a frequently used criterion for evaluating models of exchange rate determination. This paper shows that both UIP and PPP produce better exchange rate forecasts at the ten-year horizon than a random walk without drift. There are two novelties relative to previous studies. First, the effects of extending the horizons beyond four years have not been investigated. This is relevant because the influence of fundamental variables has been shown to increase with the forecasting horizon, and it may take considerably more than four years to reach the long run equilibrium in the case of exchange rates. Second, the exchange rate forecasts implied by uncovered interest parity have been neglected in this literature. UIP is typically rejected in empirical tests using data on short-term interest rates. However, long-term interest rates appear to be a quantitatively important determinant of nominal exchange rate changes.

Keywords: Exchange rates; Prediction

JEL-codes: F31; F47

21 pages, December 28, 2001

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