DP4958 Forecasting the Spot Exchange Rate with the Term Structure of Forward Premia: Multivariate Threshold Cointegration

Author(s): Michel R van Tol, Christian C Wolff
Publication Date: March 2005
Keyword(s): foreign exchange, multivariate threshold cointegration, TAR models
JEL(s): C51, C53, F31
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4958

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).