The Effect of Non-linearities

Abstract

It has been suggested that inability to outperform the random walk may result from the use of exchange rate models that are linear in parameters when the exchange rate is a non-linear function of macroeconomic variables. It is well documented that many functional relations in finance are intrinsically non-linear and that there may be non-linearities in exchange rate adjustment. We find that the forecasting performance of exchange rate models (in terms of the magnitude of error) improves substantially when specified as a non-linear error correction model. Despite this finding, the non-linear model cannot produce an RMSE that is numerically smaller and statistically different from that of the random walk.