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Forecasting Exchange Rates: The Multi-State Markov-Switching Model with Smoothing

Chunming Yuan

No 09-115, UMBC Economics Department Working Papers from UMBC Department of Economics

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.

Keywords: Exchange Rate; Forecasting; Markov-Switching; Smoothing; HP-Filter (search for similar items in EconPapers)
JEL-codes: C32 C53 F31 F47 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2008-05-01, Revised 2009-11-01
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http://www.umbc.edu/economics/wpapers/wp_09_115.pdf (application/pdf)

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Journal Article: Forecasting exchange rates: The multi-state Markov-switching model with smoothing (2011) Downloads
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