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Which continuous-time model is most appropriate for exchange rates?

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  • Erdemlioglu, Deniz
  • Laurent, Sébastien
  • Neely, Christopher J.

Abstract

This paper evaluates the most appropriate ways to model diffusion and jump features of high-frequency exchange rates in the presence of intraday periodicity in volatility. We show that periodic volatility distorts the size and power of conventional tests of Brownian motion, jumps and (in)finite activity. We propose a correction for periodicity that restores the properties of the test statistics. Empirically, the most plausible model for 1-min exchange rate data features Brownian motion and both finite activity and infinite activity jumps. Test rejection rates vary over time, however, indicating time variation in the data generating process. We discuss the implications of results for market microstructure and currency option pricing.

Suggested Citation

  • Erdemlioglu, Deniz & Laurent, Sébastien & Neely, Christopher J., 2015. "Which continuous-time model is most appropriate for exchange rates?," Journal of Banking & Finance, Elsevier, vol. 61(S2), pages 256-268.
  • Handle: RePEc:eee:jbfina:v:61:y:2015:i:s2:p:s256-s268
    DOI: 10.1016/j.jbankfin.2015.09.014
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    Cited by:

    1. repec:eee:econom:v:202:y:2018:i:1:p:18-44 is not listed on IDEAS
    2. Lahaye, Jerome & Neely, Christopher J., 2014. "The role of jumps in volatility spillovers in foreign exchange markets: meteor shower and heat waves revisited," Working Papers 2014-34, Federal Reserve Bank of St. Louis, revised 19 Sep 2016.

    More about this item

    Keywords

    Exchange rates; Brownian motion; Volatility; Jumps; Intraday periodicity; High-frequency data;

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G01 - Financial Economics - - General - - - Financial Crises

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