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Compound volatility processes in EMS exchange rates

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  • Michael Dueker

Abstract

This paper introduces a compound GARCH/markov switching model to add flexibility to the GARCH model in order to model the volatilities of exchange rates in target zones subject to realignments. The compound volatility model endogenizes the weights given to realignments (and all other shocks) in the GARCH process. Previous GARCH applications to EMS exchange rates took polar positions by arbitrarily placing full or zero weight on realignment shocks. Markov switching in the student-t degrees-of-freedom parameter is shown to make the difference between rejection and acceptance of goodness-of-fit tests for four of the six EMS currencies studied.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 1994-016.

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Date of creation: 1995
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Handle: RePEc:fip:fedlwp:1994-016

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Keywords: Foreign exchange rates;

References

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  1. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
  2. Nelson, Daniel B., 1990. "ARCH models as diffusion approximations," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 7-38.
  3. Kim, C-J., 1991. "Dynamic Linear Models with Markov-Switching," Papers 91-8, York (Canada) - Department of Economics.
  4. Nelson, Daniel B., 1992. "Filtering and forecasting with misspecified ARCH models I : Getting the right variance with the wrong model," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 61-90.
  5. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  6. Tim Bollerslev, 1986. "Generalized autoregressive conditional heteroskedasticity," EERI Research Paper Series EERI RP 1986/01, Economics and Econometrics Research Institute (EERI), Brussels.
  7. Cai, Jun, 1994. "A Markov Model of Switching-Regime ARCH," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 309-16, July.
  8. Kim, Chang-Jin, 1993. "Sources of Monetary Growth Uncertainty and Economic Activity: The Time-Varying-Parameter Model with Heteroskedastic Disturbances," The Review of Economics and Statistics, MIT Press, vol. 75(3), pages 483-92, August.
  9. Filardo, Andrew J, 1994. "Business-Cycle Phases and Their Transitional Dynamics," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 299-308, July.
  10. Hamilton, James D. & Susmel, Raul, 1994. "Autoregressive conditional heteroskedasticity and changes in regime," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 307-333.
  11. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 39-70.
  12. Fred G M C Nieuwland & Willem F C Verschoor & Christian C P Wolff, 1990. "EMS Exchange Rates," CEPR Financial Markets Paper 0002, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
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