Regime shifts and forecasting errors in exchange rates

In this paper, we empirically investigate the well-documented forward premi um anomaly in terms of the Forecasting errors of the regime shifts in exces s returns on the exchange rates. We use a simple regime-switching model to quantify,the forecasted part and the forecasting errors of the shifts. The frequent shifts lead to the systematic forecasting errors of the regime shi fts. We find the forecasting errors play a dominant role to explain the ano maly, using quarterly data for the U.S. dollar relative to the British poun d, the German mark, and the Japanese yen during 1980's and 1990's.