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Markov Switching in Exchange Rate Models: Will More Regimes Help?

Author

Listed:
  • Josh Stillwagon
  • Peter Sullivan

    () (Department of Economics, Trinity College)

Abstract

This paper examines the performance of Markov switching models (MSM) of the exchange rate using a data driven approach to determine the number of regimes. The analysis is conducted for the British pound/USD over the last thirty years with alternative specifications from the literature. A noteworthy finding is that there is a close correspondence among the number of regimes that minimizes mean square forecast errors, the number of regimes selected by traditional information criteria (but not Markov switching specific information criteria), and the fewest regimes with well-behaved residuals. Although allowing for more regimes yields improvement over single or two regime models, the MSM is still unable to outperform a random walk.

Suggested Citation

  • Josh Stillwagon & Peter Sullivan, 2016. "Markov Switching in Exchange Rate Models: Will More Regimes Help?," Working Papers 1602, Trinity College, Department of Economics.
  • Handle: RePEc:tri:wpaper:1602
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    File URL: http://internet2.trincoll.edu/repec/WorkingPapers2016/WP16-02.pdf
    File Function: First version, 2016
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    More about this item

    Keywords

    Exchange rates; Markov Switching; Monetary Models; Segmented Trends;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • C24 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Truncated and Censored Models; Switching Regression Models; Threshold Regression Models

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