Effect of Oil Prices on Exchange Rate Movements in Korea and Japan Using Markov Regime-Switching Models

We examined the effects of oil prices along with fundamental economic variables on exchange rate movements in the Korean and Japanese foreign exchange markets, using two-regime Markov Regime Switching Models (MRSMs) over the period from January 1991 to March 2019. We selected the best MRSMs explaining their exchange rate movements using the Maximum Log-Likelihood and Akaike Information Criteria, and analyze effects of oil prices on their exchange rates based on the selected best MRSMs. We consider two regimes, regime 1 with high-volatility and regime 2 with low-volatility. In Korea, two apparent regimes are observed, and unstable regime 1 consists of two distinct prolonged periods, the 1997 Asian Financial Crisis and the 2008 Global Financial Crisis. Meanwhile in Japan, no evident prolonged regimes are observed. Rather, the two regimes occasionally alternate. Oil prices influence exchange rate movements in regime 2 with low-volatility in Korea, while they do not influence exchange rate movements in either regimes in Japan. The Japanese foreign exchange market is more resistant to external oil price shocks because the Japanese industry and economy has less dependence on oil than Korea.