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Discussion Paper Details

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Title: Forecasting the Spot Exchange Rate with the Term Structure of Forward Premia: Multivariate Threshold Cointegration

Author(s): Michel R van Tol and Christian C Wolff

Publication Date: March 2005

Keyword(s): foreign exchange, multivariate threshold cointegration and TAR models

Programme Area(s): Financial Economics

Abstract: In this paper we develop a multivariate threshold vector error correction model of spot and forward exchange rates that allows for different forms of equilibrium reversion in each of the cointegrating residual series. By introducing the notion of an indicator matrix to differentiate between the various regimes in the set of nonlinear processes we provide a convenient framework for estimation by OLS. Empirically, out-of sample forecasting exercises demonstrate its superiority over a linear VECM, while being unable to out-predict a (driftless) random walk model. As such we provide empirical evidence against the findings of Clarida and Taylor (1997).

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Bibliographic Reference

van Tol, M and Wolff, C. 2005. 'Forecasting the Spot Exchange Rate with the Term Structure of Forward Premia: Multivariate Threshold Cointegration'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4958