Fundamentals Models Versus Random Walk: Evidence From an Emerging Economy

ABSTRACT We analyze the predictive power of fundamentals versus random walk models for horizons from 1 to 24 months in an emerging market. Specifically, we investigate what fundamentals models outperform random walk during periods of appreciation and depreciation of the exchange rate. Furthermore, we analyze whether the fundamentals models that beat random walk contain information not considered by market expectations. Based on data from the Brazilian economy, the findings point out that some fundamentals models are useful for forecasting the exchange rate. The predictive power of fundamentals models increases in periods marked by a trend of currency appreciation or depreciation. In particular, the PPP‐type fundamentals models have greater predictive power than the random walk and add information to market expectations for different time horizons and periods of exchange rate appreciation and depreciation.