Power transformation and forecasting the magnitude of exchange rate changes

Abstract

This paper examines the impact of power transformations on the forecasting performance of AR models with respect to the magnitude of change in Australian bilateral exchange rates. The results obtained in this study suggest that the use of squared returns as per ARCH type models are generally inferior to other power transformations. The optimal power transformation is sensitive to the measure of forecasting performance chosen although it is close to the returns themselves as per a Taylor/Schwert type model.