Switching between Chartists and Fundamentalists: A Markov Regime-Switching Approach

Since the early 1980s, models based on economic fundamentals have been poor at explaining the movements in the exchange rate (Messe, 1990). In response to this problem, Frankel and Froot (1988) developed a model where two approaches are used to forecast the exchange rate. The fundamentalist approach, where the forecast is based upon economic fundamentals, continues to be used. This models innovation is that the chartist approach, where the forecast is based upon the past behaviour of the exchange rate, is also used. A feature of this chartist-and-fundamentalist (c&f) model is that these two approaches relative importance varies over time. As this weighting is unobserved, the c&f model cannot be estimated or tested using standard techniques. We purpose to use Markov regime-switching techniques to overcome these difficulties and test the model. By defining the two groups different methods of forecasting as regimes, we rewrite the c&f model as a regime-switching model. This approach is used here to test for chartist and fundamentalist behaviour in the Canada-US daily exchange rate between 1983 and 1992. We find favourable though inconclusive evidence for the c&f model. Accordingly, we make suggestions for further research. Copyright @ 1997 by John Wiley & Sons, Ltd. All rights reserved.