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Can Markov switching models predict excess foreign exchange returns?

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  • Dueker, Michael
  • Neely, Christopher J.

Abstract

This paper merges the literature on technical trading rules with the literature on Markov switching to develop economically useful trading rules. The Markov models' out-of sample, excess returns modestly exceed those of standard technical rules and are profitable over the most recent subsample. A portfolio of Markov and standard technical rules outperforms either set individually, on a risk-adjusted basis. The Markov rules' high excess returns contrast with mixed performance on statistical tests of forecast accuracy. There is no clear source for the trends, but permitting the mean to depend on higher moments of the exchange rate distribution modestly increases returns.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 31 (2007)
Issue (Month): 2 (February)
Pages: 279-296

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Handle: RePEc:eee:jbfina:v:31:y:2007:i:2:p:279-296

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References

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  1. Dittmar, Robert & Neely, Christopher J & Weller, Paul, 1996. "Is Technical Analysis in the Foreign Exchange Market Profitable? A Genetic Programming Approach," CEPR Discussion Papers 1480, C.E.P.R. Discussion Papers.
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  12. Michael Dueker, 1995. "Markov switching in GARCH processes and mean reverting stock market volatility," Working Papers 1994-015, Federal Reserve Bank of St. Louis.
  13. Olson, Dennis, 2004. "Have trading rule profits in the currency markets declined over time?," Journal of Banking & Finance, Elsevier, vol. 28(1), pages 85-105, January.
  14. repec:att:wimass:9222 is not listed on IDEAS
  15. Levich, Richard M. & Thomas, Lee III, 1993. "The significance of technical trading-rule profits in the foreign exchange market: a bootstrap approach," Journal of International Money and Finance, Elsevier, vol. 12(5), pages 451-474, October.
  16. Christopher J. Neely, 1997. "Technical analysis in the foreign exchange market: a layman's guide," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 23-38.
  17. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
  18. Blake LeBaron, . "Do Moving Average Trading Rule Results Imply Nonlinearities in Foreign Exchange?," Working papers _005, University of Wisconsin - Madison.
  19. Dewachter, Hans, 2001. "Can Markov switching models replicate chartist profits in the foreign exchange market?," Journal of International Money and Finance, Elsevier, vol. 20(1), pages 25-41, February.
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