Regime switching in foreign exchange rates:: Evidence from currency option prices

Abstract

This paper examines the ability of regime-switching models to capture the dynamics of foreign exchange rates. First we test the ability of the models to fit foreign exchange rate data in-sample and forecast variance out-of-sample. A regime-switching model with independent shifts in mean and variance exhibits a closer fit and more accurate variance forecasts than a range of other models. Next we use exchange-traded currency options to determine whether market prices reflect regime-switching information. We find that observed option prices are significantly different from their theoretical levels determined by a regime-switching option valuation model and that a simulated trading strategy based on regime-switching option valuation generates higher profits than standard single-regime alternatives. Overall, the results indicate that observed option prices do not fully reflect regime-switching information.