CRIEFF Discussion Paper Number 0103

Non Linear Error Correction in Spot and Forward Exchange Rates

David McMillan and Angela J Black

Abstract
Recent research has increasingly suggested that exchange rates may be characterised by non-linear behaviour which results from the existence of market frictions. This paper examines whether such non-linear behaviour is evident, not in rates themselves, but in the adjustment of rates back to some fundamental equilibrium. Thus, we examine a series of six spot and forward exchange rates to see whether a non-linear error-correction model, which exhibits asymmetric adjustment back to equilibrium either in terms of the size of the deviation from equilibrium or the sign of the deviation outperforms either a random walk model for rates or a linear error-correction model. Our in-sample results suggest that the non-linear models outperform both the linear models, with evidence of significant sign and size threshold effects. Out-of-sample forecasts lend further support for the non-linear models.

JEL Classifications
G12, G13

Keywords
Non-Linear Error-Correction, Forecasting, Spot and Forward Exchange Rates

David G McMillan
University of St Andrews

Angela J Black
University of Aberdeen

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