Forecasting exchange rates: The multi-state Markov-switching model with smoothing |
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| Authors: | Chunming Yuan |
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| Affiliation: | 1. Department of Business and Economics, University of Passau, Germany;2. Centre for Financial Econometrics, School of Accounting, Economics and Finance, Deakin University, Australia;1. BESTMOD, Institut Supérieur de Gestion de Tunis, Université de Tunis, Tunisia;2. Department of Economics, Eastern Mediterranean University, Famagusta, Northern Cyprus, via Mersin 10, Turkey;3. Department of Economics, University of Pretoria, Pretoria 0002, South Africa;4. College of Sciences and Humanities in Slayel, Salman bin Abdulaziz University, Kingdom of Saudi Arabia |
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| Abstract: | This paper presents an exchange rate forecasting model which combines the multi-state Markov-switching model with smoothing techniques. The model outperforms a random walk at short horizons and its superior forecastability appears to be robust over different sample spans. Our finding hinges on the fact that exchange rates tend to follow highly persistent trends and accordingly, the key to beating the random walk is to identify these trends. An attempt to link the trends in exchange rates to the underlying macroeconomic determinants further reveals that fundamentals-based linear models generally fail to capture the persistence in exchange rates and thus are incapable of outforecasting the random walk. |
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