Markov regimes switching with monetary fundamental-based exchange rate model

This paper examines whether the exchange rates of the Asia-Pacific countries can be captured by the Markov switching model (MSM). Using data from January 2000 to December 2011, the real interest differential (RID) model is tested first. However, supporting evidence is limited, and results are markedly different across the countries. It is worth noting that the signs on the coefficients for fundamental factors are mostly wrong from the RID model perspective. By using the MSM-RID model, the results identify that two regimes exist and persist, which is consistent with earlier literature indicating that there are complex influences in exchange rate determination. This leads to the conclusion that the results are strongly in favor of a nonlinear relationship between exchange rate volatility and fundamental factors. When the probabilities transition matrixes of MSM are allowed to change [MSM-RID-time varying transition probabilities model (TVTP)], it is found that MSM-RID-TVTP outperforms the MSM-RID model. MSM classifies the currencies regimes and provides information about the change of currency prices in some Asian-Pacific currencies.