Nonlinear dynamics in foreign exchange rates
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abstract
This paper investigates whether the behavior of real and nominal foreign exchange rates as well as interest rates are governed by nonlinear dynamics; it also explores whether observed deviations from parity conditions exhibit nonlinear dependence. Standard statistical tests for randomness, such as autocorrelation tests, have low power against a large class of deterministic, nonlinear processes. Discerning nonrandomness of innovations in exchange rates is important for a variety of reasons. For example, many models of international asset pricing assume exchange rates to follow a random walk. Furthermore, nonlinear patterns in deviations from various exchange rate parities have implications for the existence of a time-varying foreign exchange risk premium. With the use of the BDS statistic and a correlation dimension analysis, this paper's primary findings are that (1) foreign exchange markets have become increasingly complex and therefore less amenable to forecasting over time; (2) although forward exchange risk premia are statistically significant and display a deterministic structure, this structure is complex and therefore not easily discernible; and (3) innovations in real exchange rates are consistent with a Purchasing Power Parity equilibrium. 1999 Elsevier Science Inc.
