| 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. |