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A Three-State Markov-Modulated Switching Model for Exchange Rates

Idowu Ayodeji ()

Abstract of Economic, Finance and Management Outlook, 2016, vol. 6, 12

Abstract: Several authors have investigated the long swings hypothesis in exchange rates using a two-state Markov switching model. This study developed a model to investigate long swings hypothesis in currencies which may exhibit a three-state pattern. The proposed model was then used to investigate the long swings hypothesis in the Nigerian naira (NGN) with respect to US dollars (USD). On the strength of empirical evidence, NGN/USD was decomposed into three regimes of depreciation, low and high appreciation. Empirical results showed evidence of asymmetric swings, such that the Nigerian naira experienced long, gradual swings in appreciation period and short, sharp swings when exchange rates fall. The proposed model was also used to analyze the exchange rate cycle in Nigeria from January 2004 to May 2016. Taking 0.5 as the benchmark for smoothing probabilities, our model provided a clear reading of the cycle in a manner that is consistent with the realities of the exchange rate movements in Nigeria. In addition, duration results indicated that the depreciation, low and high appreciation periods are expected to last for 1, 11 and 15 months, respectively.

Date: 2016
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Handle: RePEc:pkp:ecfmao:2016:p:12:vol:6