Exchange Rate Returns Standardized by Realized Volatility Are (Nearly) Gaussian
The prescriptions of modern financial risk management hinge critically on the associated characterization of the distribution of future returns (cf., Diebold, Gunther and Tay, 1998, and Diebold, Hahn and Tay, 1999). Because volatility persistence renders high-frequency returns temporally dependent (e.g., Bollerslev, Chou and Kroner, 1992), it is the conditional return distribution, and not the unconditional distribution, that is of relevance for risk management. This is especially true in high-frequency situations, such as monitoring and managing the risk associated with the day-to-day operations of a trading desk, where volatility clustering is omnipresent. Exchange rate returns are well-known to be unconditionally symmetric but highly leptokurtic. Standardized daily or weekly returns from ARCH and related stochastic volatility models also appear symmetric but leptokurtic; that is, the distributions are not only unconditionally, but also conditionally leptokurtic, although less so than unconditionally.1 A sizable literature explicitly attempts to model the fat-tailed conditional distributions, including, for example, Bollerslev (1987), Engle and Gonzalez-Rivera (1991), and Hansen (1994).
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- Francis X. Diebold & Jinyong Hahn & Anthony S. Tay, 1999. "Multivariate Density Forecast Evaluation And Calibration In Financial Risk Management: High-Frequency Returns On Foreign Exchange," The Review of Economics and Statistics, MIT Press, vol. 81(4), pages 661-673, November.
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- Nelson, Daniel B., 1996. "A Note on the Normalized Errors in ARCH and Stochastic Volatility Models," Econometric Theory, Cambridge University Press, vol. 12(01), pages 113-128, March.
- Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
- Engle, Robert F & Gonzalez-Rivera, Gloria, 1991. "Semiparametric ARCH Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 9(4), pages 345-359, October.
- Hsieh, David A, 1989. "Modeling Heteroscedasticity in Daily Foreign-Exchange Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 7(3), pages 307-317, July.
- Taylor, Stephen J. & Xu, Xinzhong, 1997. "The incremental volatility information in one million foreign exchange quotations," Journal of Empirical Finance, Elsevier, vol. 4(4), pages 317-340, December.
- Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
- Bollerslev, Tim, 1987. "A Conditionally Heteroskedastic Time Series Model for Speculative Prices and Rates of Return," The Review of Economics and Statistics, MIT Press, vol. 69(3), pages 542-547, August.
- Diebold, Francis X & Gunther, Todd A & Tay, Anthony S, 1998. "Evaluating Density Forecasts with Applications to Financial Risk Management," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 863-883, November.
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