Stochastic Segmented Trends in the Exchange Rate: The Greek Drachma/U.S. Dollar Rate, 1981-1998

It is shown that when the Central Bank manages the interest rate differential through standard interventions, aimed at offsetting exogenous disturbances in the foreign exchange market, and agents do not observe the current state of policy, then a Markov switching regimes representation is appropriate for exchange rate movements. Indeed, using monthly data on the GRD/$ exchange rate, over the period 1981-1998, we obtain evidence that a stochastic segmented trends model identifies the tuning points of the GRD/$ exchange rate series, beats naive out-of-sample forecasts, and gives good predictions which capture the devaluation of the Greek currency in March 1998.