Home About Latest Browse RSS Advanced Search

Federal Reserve Bank of Dallas
Globalization Institute Working Papers
Can long-horizon forecasts beat the random walk under the Engel-West explanation?
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.


Download Full text
Cite this item
Charles Engel & Jian Wang & Jason J. Wu, Can long-horizon forecasts beat the random walk under the Engel-West explanation?, Federal Reserve Bank of Dallas, Globalization Institute Working Papers 36, 2009.
More from this series
JEL Classification:
Subject headings:
Keywords: Foreign exchange rates ; Financial markets ; Asset pricing ; Forecasting ; Random walks (Mathematics) ; Regression analysis
For corrections, contact Amy Chapman ()
Fed-in-Print is the central catalog of publications within the Federal Reserve System. It is managed and hosted by the Economic Research Division, Federal Reserve Bank of St. Louis.

Privacy Legal