Long Swings in the Exchange Rate: Are they in the Data and Do Markets Know It?
James D. Hamilton
The value of the dollar appears to move in one direction for long periods
of time. We develop a new statistical model of exchange rate dynamics as a
sequence of stochastic, segmented time trends. The paper implements new
techniques for parameter estimation and hypothesis testing for this framework.
We reject the null hypothesis that exchange rates follow a random walk in
favor of our model of long swings. Our model also generates better forecasts
than a random walk. We conclude that persistent movement in the value of the
dollar is a fact that calls for greater attention in the theory of exchange
The model is a natural framework for assessing the importance of the
"peso problem" for the dollar. It allows for the expectation of future
exchange rates to be influenced by the probability of a change in regime. We
nonetheless reject uncovered interest parity. The forward premium appears
frequently to put too high a probability on a change in regime.
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