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Why is it so difficult to beat the Random Walk Forecast of Exchange Rates?
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Why is it so difficult to beat the Random Walk Forecast of Exchange Rates?

Author

Listed:
  • Lutz Kilian

    (University of Michigan and CEPR)

  • Mark P. Taylor

    (University of Warwick and CEPR)

Abstract

We propose a stylized exchange rate model based on diversity and weight ofopinion. Our model departs from standard assumptions in that we allow forheterogeneous agents. We show that such a model can explain both the observedvolatility and the persistence of real and nominal exchange rate movements and thusin some measure resolves Rogoffs (1996) purchasing power parity puzzle. Ourempirical analysis reconciles the well-known difficulties in beating the random walkforecast model with the statistical evidence of nonlinear mean reversion in deviationsfrom fundamentals. We find strong evidence of long-horizon predictability both intheory and in practice. We also explain why it is difficult to exploit this predictabilityin out-of-sample forecasts. Our results not only lend support to economists' beliefsthat the exchange rate is inherently predictable, but they also help us to understandthe reluctance of applied forecasters to abandon chartists methods in favor ofmodels based on economic fundamentals.

Suggested Citation

  • Lutz Kilian & Mark P. Taylor, 2001. "Why is it so difficult to beat the Random Walk Forecast of Exchange Rates?," Tinbergen Institute Discussion Papers 01-031/4, Tinbergen Institute.
    • Handle: RePEc:tin:wpaper:20010031
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    References listed on IDEAS

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    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F47 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Forecasting and Simulation: Models and Applications

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