The Forecasting Performance of Regime-Switching Models of Speculative Behavior for Exchange Rates

Abstract

This study provides evidence of periodically collapsing bubbles in the British pound to US dollar exchange rate in the post-1973 period. We develop two- and three-state regime-switching models that relate the expected exchange rate return to the bubble size and to an additional explanatory variable. Specifically, we consider six alternative explanatory variables that have been proposed in the literature as early warning indicators of a currency crisis. Our findings suggest that the regime-switching models are, in general, more accurate than the Random Walk model in terms of both statistical and especially economic evaluation criteria for exchange rate forecasts. Our three-state regime-switching model outperforms the two-state models and among the variables considered in our analysis, the short-term interest rate is the optimal variable, closely followed by imports, in both statistical and economic evaluation terms. Results are more promising for one-month predictions and are qualitatively robust to the calculated bubble measure.