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Compound volatility processes in EMS exchange rates

  • Michael J. Dueker

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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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
Date of revision:
Handle: RePEc:fip:fedlwp:1994-016
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  1. 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.
  2. 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.
  3. 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..
  4. Hamilton, James D. & Susmel, Raul, 1994. "Autoregressive conditional heteroskedasticity and changes in regime," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 307-333.
  5. Paul R. Krugman, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 669-682.
  6. Nelson, Daniel B., 1990. "ARCH models as diffusion approximations," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 7-38.
  7. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 39-70.
  8. 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.
  9. Kim, Chang-Jin, 1994. "Dynamic linear models with Markov-switching," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 1-22.
  10. 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.
  11. 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.
  12. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
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