Several authors have recently investigated the predictability of exchange rates by fitting a sequence of long-horizon error-correction equations. We show by means of a simulation study that, in small to medium samples, inference from this regression procedure depends on the null hypothesis that is used to generate empirical critical values. The standard assumption of a stationary error-correction term between exchange rates and fundamentals biases the results in favor of predictive power. Our results show that evidence of long-horizon predictability weakens when using empirical critical values generated under the more stringent null of no cointegration. Likewise, results are weakened using critical values generated under the null that exchange rates and fundamentals are generated by an unrestricted VAR with no integration restrictions.

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