Bayesian Markov switching model for BRICS currencies' exchange rates

Abstract

AbstractExchange rate modeling has always fascinated researchers because of its complex macroeconomic dynamics. This study documents the exchange rate dynamics of major emerging economies after accounting for their macroeconomic cycles and explores the Bayesian Vector Error Correction Model (VECM) Markov Regime switching model, which uses time‐varying transition probabilities. The main objective is to study the exchange rate dynamics of Brazil, Russia, India, China, and South Africa (BRICS) vis‐à‐vis the US dollar. The Bayesian setup uses two hierarchal shrinkage priors, the normal‐gamma (NG) prior and the Litterman prior, for parameters' estimation. These shrinkage priors allow for a more comprehensive assessment of the regime‐specific coefficients. The model performed well in differentiating between the two regimes for all currencies. The Russian ruble was identified to be the most depreciated currency, whereas the African Rand was the most appreciated. The evaluation of model features revealed that many regime‐specific coefficients differed significantly from their common mean. A forecasting exercise was then performed for the out‐of‐sample period to assess the model's performance. A significant improvement was observed over the basic random walk (RW) model and the linear Bayesian vector autoregression (BVAR) model.