The dynamics of DM/£ exchange rate volatility: A SWARCH analysis

Abstract

This paper applies the switching ARCH model introduced by Hamilton and Susmel (1994) to weekly DM/£ exchange rates for the period March 1987-December 1994. The sample period spans the UK's ERM tenure, which lasted until the currency crisis of September 1992. The SWARCH model generalizes standard ARCH models by allowing the conditional variance to experience jumps between discrete states or regimes. The SWARCH model is shown to provide a unified statistical framework for investigating two issues of interest in the literature: (i) the evolution of volatility and its implications for ERM credibility and (ii) the effects of regime shifts on the stochastic process governing conditional volatility. © 1998 John Wiley & Sons, Ltd.