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Conditional Volatility of Exchange Rates Under a Target Zone

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Author Info
Robert F. Engle
Yin-Feng Gau

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Abstract

To study the impact of institutional features of target zones on the conditional volatility of exchange rates, this paper proposes a simple and intuitive model to incorporate the announced information in the bands. Observing the statistical characteristics of the EMS cross rate returns- mean reversion and heteroskedasticity, we fit a GARCH(1,1)-MA(1) specification incorporating the deviation of exchange rates from the central parity. This model allows us to easily examine the relationship between the conditional volatility and the position of spot rates. We find in particular, that for the Irish punt and Italian lira DM rates, the conditional volatility increases as the exchange rate approaches the edges of the band. We extend the above univariate model to a multivariate setting to take account of the cross country interactions in the EMS, by including a vector consisting of all EMS currencies' positions in the GARCH equation. The estimation results show that other currencies' positions do affect the conditional volatility of a specific EMS currency. Understanding the importance of intra-ERM coherence and the multilateral commitment on the central parity, we follow Pill(1994) to derive an "effective band" model to examine how the multilateral grid affects the conditional volatility. However, the estimation results suggest that the full set of all deviations from official central parity of each member country explains the volatility better than does simply the deviation from the effective band.

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Paper provided by Department of Economics, UC San Diego in its series University of California at San Diego, Economics Working Paper Series with number 97-06.

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Date of creation: Feb 1997
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Handle: RePEc:cdl:ucsdec:97-06

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  1. Vlaar, Peter J G & Palm, Franz C, 1993. "The Message in Weekly Exchange Rates in the European Monetary System: Mean Reversion, Conditional Heteroscedasticity, and Jumps," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(3), pages 351-60, July.
  2. Nieuwland, Frederick G M C & Verschoor, Willem F C & Wolff, Christian C P, 1994. "Stochastic trends and jumps in EMS exchange rates," Journal of International Money and Finance, Elsevier, vol. 13(6), pages 699-727, December. [Downloadable!] (restricted)
  3. Michael Dueker, 1995. "Compound volatility processes in EMS exchange rates," Working Papers 1994-016, Federal Reserve Bank of St. Louis. [Downloadable!]
  4. Bollerslev, Tim, 1990. "Modelling the Coherence in Short-run Nominal Exchange Rates: A Multivariate Generalized ARCH Model," The Review of Economics and Statistics, MIT Press, vol. 72(3), pages 498-505, August. [Downloadable!] (restricted)
  5. Kees G. Koedijk & Philip A. Stork & Casper G. De Vries, 1998. "An EMS target zone model in discrete time," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 13(1), pages 31-48. [Downloadable!]
  6. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April. [Downloadable!] (restricted)
  7. Neely, Christopher J., 1999. "Target zones and conditional volatility: The role of realignments," Journal of Empirical Finance, Elsevier, vol. 6(2), pages 177-192, April. [Downloadable!] (restricted)
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  1. Peter Brandner & Harald Grech & Helmut Stix, 2001. "The Effectiveness of Central Bank Intervention in the EMS. The Post 1993 Experience," WIFO Working Papers 168, WIFO. [Downloadable!]
    Other versions:
  2. TEYSSIERE, Gilles, 2003. "Interaction models for common long-range dependence in asset price volatilities," CORE Discussion Papers 2003026, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE). [Downloadable!]
  3. Jarko Fidrmuc & Roman Horváth, 2006. "Credibility of Exchange Rate Policies in Selected EU New Members: Evidence from High Frequency Data," Working Papers IES 2006/28, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Oct 2006. [Downloadable!]
  4. Joseph D. ALBA & Donghyun PARK, 2004. "Granger Causality Among Pre-Crisis East Asian Exchange Rates," Econometric Society 2004 Far Eastern Meetings 697, Econometric Society. [Downloadable!]
  5. Emese Lazar & Carol Alexander, 2006. "Normal mixture GARCH(1,1): applications to exchange rate modelling," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 21(3), pages 307-336. [Downloadable!]
  6. Fernandes, Marcelo & Rocha, Marco Aurélio dos Santos, 2006. "Are price limits on futures markets that cool? Evidence from the Brazilian Mercantile and Futures Exchange," Economics Working Papers (Ensaios Economicos da EPGE) 630, Graduate School of Economics, Getulio Vargas Foundation (Brazil). [Downloadable!]
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  7. Nikiforos T. Laopodis, 2001. "Time-Varying Behavior And Asymmetry In Ems Exchange Rates," International Economic Journal, Korean International Economic Association, vol. 15(4), pages 81-94, December. [Downloadable!] (restricted)
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