Chartist Prediction in the Foreign Exchange Market. Evidence from the Daily Dollar/DM Exchange Rate

In this study a regime switching approach is applied to estimate the chartist and fundamentalist (c&f) exchange rate model originally proposed by Frankel and Froot (1986). The empirical results suggest that this model does successfully explain daily DM/Dollar forward exchange rate dynamics from 1982 to 1998. Moreover, our findings turned out to be relative robust by estimating the model in subsamples. A particular focus of this study is on testing the c&f model against alternative regime switching specifications applying likelihood ratio tests. The results are striking. Nested atheoretical models like the popular segmented trends model suggested by Engel and Hamilton (1990) are rejected in favour of the c&f model. Finally, the c&f regime switching model seems to describe the data much better than a competing regime switching GARCH(1,1) model.