Periodically collapsing bubbles in exchange rates

Abstract

Nowadays, it is an undeniable fact that forecasting exchange rates are of great interest to all participants in international financial markets. Despite the efforts of many economists to examine and explain the phenomenon of the financial bubble, its identification seems to be very difficult. The objective of this paper is to examine the existence, duration, and size of financial bubbles in three exchange rate markets by using various two-state switching regime models. More in detail, we use these models to describe the dynamics in three exchange rates. These currencies are the British Pound/US Dollar, Canadian Dollar /US Dollar and the Japanese Yen/US Dollar. Moreover, we test the predictive ability of our models to detect unusual positive or negative movements in these exchange rates. Given that our findings provide evidence supporting the existence of financial bubbles in the exchange rate markets, in most cases, our regime-switching models seem to predict extreme market movements.