Evaluating random walk forecasts of exchange rates

Abstract

PurposeThe random walk forecast of exchange rate serves as a standard benchmark for forecast comparison. The purpose of this paper is to assess whether this benchmark is unbiased and directionally accurate under symmetric loss. The focus is on the random walk forecasts of the dollar/euro for 1999‐2007 and the dollar/pound for 1971‐2007.Design/methodology/approachA forecasting framework to generate the one‐ to four‐quarter‐ahead random walk forecasts at varying lead times is designed. This allows to compare forecast accuracy at different lead times and forecast horizons. Using standard evaluation methods, this paper further evaluates these forecasts in terms of unbiasedness and directional accuracy.FindingsThe paper shows that forecast accuracy improves with a reduction in the lead time but deteriorates with an increase in the forecast horizon. More importantly, the random walk forecasts are unbiased and accurately predict directional change under symmetric loss and thus are of value to a user who assigns similar cost to incorrect upward and downward move predictions in the exchange rates.Research limitations/implicationsThe one‐ to four‐quarter‐ahead random walk forecasts evaluated here are for averages of daily figures and not for the (end‐of‐quarter) rates in 3‐, 6‐, 9‐ and 12‐months. Thus, the framework is of value to a market participant who is interested in forecasting quarterly average rates rather than the end‐of‐quarter rates.Originality/valueThe exchange rate forecasting framework presented in this paper allows the evaluation of the random walk forecasts in terms of directional accuracy which (to the best of knowledge) has not been done before.