Modeling the exchange rate using price levels and country risk

Abstract

This paper builds two factor discrete time models in order to investigate the effect of sovereign risk on the nominal exchange rates in a Markov switching framework. The empirical section of the paper uses seven currencies from Chile, the Czech Republic, Hungary, Iceland, Japan, Korea, and Mexico. To measure the sovereign risk, we use the credit rating agencies’ ratings classes as proxy variable. In the empirical part, four different versions of the model are calibrated and their in-sample and out-of-sample data will be analyzed leading to the conclusion that none of the four versions dominates the others. As an additional result, it is revealed that risk has significant effect on the nominal exchange rates.

Keywords:

• exchange rate
• multifactor model
• ratings classes
• Markov-switching model

JEL classifications:

• C15
• C33
• C53
• F31

Public Interest Statement

This paper presents a method to describe the relation between country ratings and exchange rates. Up to now, in the literature, only the effect of exchange rates to country risk has been introduced, but now a model is built to the other direction of this relationship: how does the change of country risk (shown by ratings of different agencies) influence the exchange rate. We receive through the example of seven countries that as a result of a higher risk, the currency depreciates.

Acknowledgements

Gábor Regős would like to thank József Abaffy for the valuable comments to the paper and to Bálint Magyar for language revision.

Additional information

Funding

The author received no direct funding for this article.

Notes on contributors

Gábor Regős

Gábor Regős is currently working at the Hungarian Central Statistical Office and he is a PhD candidate at Corvinus University of Budapest. Before he was also affiliated with the Hungarian Financial Supervisory Authority. In 2012 he was a visiting researcher at the National Bank of Hungary and in 2013 he was a visiting lecturer at the International Business School.

His mains research topics are macroeconomics, industrial organization, and insurance.