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On the Estimation of Optimal Cutoffs for Power Laws and the Cross Section of Realized Foreign Exchange Rate Variances

Author

Listed:
  • Klaus Grobys

    (University of Vaasa, Finance Research Group, School of Accounting and Finance
    University of Vaasa, Innovation and Entrepreneurship (InnoLab))

Abstract

Extending recent research, this study introduces a novel testing procedure based on modern block bootstrap techniques and maximum likelihood estimation to investigate whether the universal power-law process governing the cross-section of realized foreign exchange (FX) rate variances exhibits a conjoint cutoff. The analysis posits that the maximum likelihood estimator for the exponent of a power law is intrinsically dependent on the selected cutoff. Our innovative test, calibrated to the cross-section of realized daily FX variances, provides evidence for the existence of such a universal cutoff. The findings have significant implications for FX risk management. Specifically, they indicate that (a) the benefits of FX risk diversification may be more constrained than previously assumed, and (b) the extent of power-law behavior in the realized variance risk of the FX market may be substantially underestimated when conventional single-equation models are employed to determine the optimal cutoff for a power law.

Suggested Citation

  • Klaus Grobys, 2026. "On the Estimation of Optimal Cutoffs for Power Laws and the Cross Section of Realized Foreign Exchange Rate Variances," Computational Economics, Springer;Society for Computational Economics, vol. 68(2), pages 1245-1292, August.
    • Handle: RePEc:kap:compec:v:68:y:2026:i:2:d:10.1007_s10614-025-11064-2
    DOI: 10.1007/s10614-025-11064-2
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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