Computers & Operations Research 30 (2003) 887–900 www.elsevier.com/locate/dsw A Bayesian vector error correction model for forecasting exchange rates An-Sing Chen a ;∗ , Mark T. Leung b a Department of Finance, National chung cheng university, Ming-Hsiung, chia-yi 621, Taiwan b Department of Management Science and Statistics, College of Business, University of Texas, San Antonio, TX 78249, USA Abstract This paper develops a new method called Bayesian Vector Error Correction Model (BVECM), which is applied to forecast 1 month ahead changes of currency exchange rates for three major Asia Pacic economies. The study also compares out-of-sample forecasting performance with those of the random walk model and the Bayesian Vector Autoregression (BVAR), which has been shown in recent studies to outperform a variety competing of econometric techniques in exchange rate forecasting. Our experimental results indicate that both BVECM and BVAR are able to forecast the changes in exchange rates better than the random walk model. In terms of conventional forecast evaluation statistics, BVECM outperforms BVAR for all three currencies examined. In addition, the bias tests nd that BVECM produces systematically less biased and more ecient out-of-sample forecasts than BVAR. Although the results of market timing tests indicate that both BVAR and BVECM have an economically signicant value in predicting the directional change in two of the three exchange rates, BVECM is shown to produce equally or more economically signicant directional change forecasts than BVAR. ? 2002 Elsevier Science Ltd. All rights reserved. Keywords: Forecasting; Currency exchange; Asia Pacic emerging economy; Bayesian vector autoregression; Error correction model 1. Introduction With the advance of technologies in transportation and telecommunication, many corporations in these two decades often conduct business in dierent parts of the world and are characterized by rapid globalization of their operations. In order to gain a competitive advantage over their rivals, a lot of corporations have established and are extending their businesses in the fast growing emerging * Corresponding author. Tel.: +886-5-272-0411, ext 34201; fax: +886-5-272-0818. E-mail addresses: nasc@ccunix.ccu.edu.tw (A.-S. Chen), mtleung@utsa.edu (M.T. Leung). 0305-0548/02/$ - see front matter ? 2002 Elsevier Science Ltd. All rights reserved. PII:S0305-0548(02)00041-2