An Empirical Application of a Random Level Shifts Model with Time-Varying Probability and Mean Reversion to the Volatility of Latin-American Forex Markets Returns

Following Xu and Perron (2014), this paper uses daily data for six Forex Latin American markets. Four models of the family of the Random Level Shift (RLS) model are estimated: a basic model where probabilities of level shift are driven by a Bernouilli variable but probability is constant; a model where varying probabilities are allowed and introduced via past extreme returns; a model with mean reversion mechanism; and a model incorporating these two features. Our results prove three striking features: first, the four RLS models fit well the data, with almost all the estimates highly significant; second, the long memory property disappears completely from the ACF, including the GARCH effects; and third, the forecasting performance is much better for the RLS models against an overall of four competitor models: GARCH, FIGARCH and two ARFIMA models.

Keywords

Forecasting, Forex Return Volatility, Latin American Forex Markets, Long memory, Mean Reversion, Random Level Shifts, Time Varying Probability

JEL Classification

C22, C52, G12