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

Abstract

Several authors have examined 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 $k$-state $(k\ge \mathrm{2})$ pattern. The proposed model was then applied to euros, British pounds, Japanese yen, and Nigerian naira. Specification measures such as AIC, BIC, and HIC favoured a three-state pattern in Nigerian naira but a two-state one in the other three currencies. For the period January 2004 to May 2016, empirical results suggested the presence of asymmetric swings in naira and yen and long swings in euros and pounds. In addition, taking $\mathrm{0.5}$ as the benchmark for smoothing probabilities, choice models provided a clear reading of the cycle in a manner that is consistent with the realities of the movements in corresponding exchange rate series.