1

THE ACADEMY OF ECONOMIC STUDIES

FACULTY OF FINANCE INSURANCE BANKS AND CAPITAL MARKETS
MASTER DAFI FINANCIAL MANAGEMENT AND CAPITAL MARKETS








Exchage rate volatility forecast








TEACHER COORDINATOR:
CONF. DR. LAURA OBREJA BRASOVEANU

STUDENT:
EUGENIA VASILICA BATIR




BUCHAREST, 2008
2
The purpose of this paper is to evidence main factors of exchange rate volatility
and the way we can forecast that volatility. Exchange rate volatility is an important fact
when dealing with foreign currencies transactions. As economic theories are showing
different determinants may influence exchange rate movements and it is important to
know those factors and to find a way to predict how exchange rates will affect your
business. The factors are grouped based on the approaches considered: traditional
approach, purchasing power parity, interest rate parity and others.
Along the time many economists tried to find the best way of forecasting
exchange rate volatility. Some of empirical researches carried on are exemplified in
Chapter 2.
Autoregressive Conditional Heteroskedasticity (ARCH) models are specifically
designed to model and forecast conditional variances. The model has the following
properties:
1) Auto regression - uses previous estimates of volatility to calculate subsequent (future)
values. Hence volatility values are closely related.
2) Heteroskedasticity - the probability distributions of the volatility varies with the
current value.
Formally, an ARCH(m) process may be expressed mathematically as

=

+ =
m
i
i n i n
x
1
2 2
(6)
The most common ARCH(m) process used to model asset price volatility dynamics is the
ARCH(1) model where
2
1
2
* *

+ =
n long n
x S (7)
or
2
1
2
) 1 (

+ =
n long n
x S (8)
The GARCH(p,q) model may be written as

= =

+ + =
p
i
q
j
j n i i n i n
x
1 1
2 2 2
(9)
The p and q denote the number of past observations of x
n-j
and
n-j
, respectively,
used to estimate
n
.
3
In the standard GARCH (1, 1) specification:
2
1
2
1
2

+ + =
+ =
t t t
t t t
x y


(8)
The first equation is the mean equation; it is written as a function of exogenous
variables with an error term. Since is the one-period ahead forecast variance based on
past information, it is called the conditional variance. The second is the conditional
variance equation; it is a function of three terms:
The mean: ;
News about volatility from the previous period, measured as the lag of the squared
residual from the mean equation:
2
1 t
(the ARCH term).
Last periods forecast variance:
2
1 t
(the GARCH term).

Some empirical studies are quoted:
Authors: Christopher J. Neely and Paul A. Weller
Models
GARCH (1,1)
2 2
1
2
t t t
+ + =


RiskMetrics one day ahead volatility
2 2
1
2
) 1 (
t t t
+ =


1 = + , = 0, = 0.94 (J.P. Morgan, 1996)
Genetic algorithms - based on the principles of natural selection; these procedures
were developed for genetic algorithms by Holland (1975) and extended to genetic
programming by Koza (1992).
Author: Robert J. Hodrick
Models
I. Estimation of Univariate Models with Monthly Data
II. An Exchange Rate Model with Weekly Data
Conclusions: there are better models for forecasting exchange rate volatility such as
RiskMetrics or Genetic Programs, even so GARCH is suitable for volatility forecast if no
other models available.

4
Chapter 3 illustrates an econometric model based on RON/EUR exchange rate
series, over January 1999 to the 15
th
of May 2008.
1.2
1.6
2.0
2.4
2.8
3.2
3.6
4.0
4.4
500 1000 1500 2000 2500 3000
RON_EUR

The model was carried on using EViews 4.1 version. The models actually used
where GARCH models.
The results showed something evident, that RON/EUR exchange rate has a high
volatility; news are quickly absorbed into exchange rate value and do not produce
persistent changes of trend.
Five variants of GARCH models were drawn up based on past information and
series descriptive statistics, correlation and stationary (mean reverting) characteristics.
In order to obtain a stationary series it were necessary two operations: logarithm
and first difference. First difference of RON/EUR logarithm series was the stationary
series considered when GARCH models were projected.
5
-.06
-.04
-.02
.00
.02
.04
.06
.08
500 1000 1500 2000 2500 3000
DL_RON_EUR

Of all five models, according to Akaike info criterion, the best model for
predicting RON/EUR volatility was chosen.
Terms GARCH1 GARCH2 GARCH3 GARCH4 GARCH5
C 0.0002360 0.0002400 0.0002380 0.0002340 0.0002330
AR(1) - 0.0519310 -0.1985470 0.0530310 0.2814410
MA(1) - - 0.2540670 - -0.2286930
MA(2) - - - -0.0308490 -0.0448840
Akaike info criterion -7.6671990 -7.6688350 -7.6683980 -7.6688140 -7.6681380
Schwarz criterion -7.6574830 -7.6566860 -7.6538190 -7.6542350 -7.6511290
Durbin-Watson stat 1.8297000 1.9248780 1.9326890 1.9292170 1.9289060


GARCH2 model [finally validated]:

Estimation Command:
=====================
ARCH DL_RON_EUR AR(1) C @

Estimation Equation:
=====================
DL_RON_EUR =C(1) +[AR(1)=C(2)]

Substituted Coefficients:
=====================
DL_RON_EUR =0.000239577877 +[AR(1)=0.0519312513]


6
Dependent Variable: DL_RON_EUR
Method: ML - ARCH (Marquardt)
Date: 06/25/08 Time: 07:24
Sample(adjusted): 3 2378
Included observations: 2376 after adjusting endpoints
Convergence achieved after 21 iterations
Variance backcast: ON
Coefficient Std. Error z-Statistic Prob.
C 0.000240 9.47E-05 2.528737 0.0114
AR(1) 0.051931 0.019674 2.639552 0.0083
Variance Equation
C 2.89E-07 5.20E-08 5.549140 0.0000
ARCH(1) 0.136413 0.007422 18.38059 0.0000
GARCH(1) 0.870345 0.006321 137.7006 0.0000
R-squared 0.005164 Mean dependent var 0.000431
Adjusted R-squared 0.003485 S.D. dependent var 0.006192
S.E. of regression 0.006181 Akaike info criterion -7.668835
Sum squared resid 0.090578 Schwarz criterion -7.656686
Log likelihood 9115.576 F-statistic 3.076649
Durbin-Watson stat 1.924878 Prob(F-statistic) 0.015387
Inverted AR Roots .05

Probability associated to mean and variance equations coefficients are less than
5%;
0
100
200
300
400
500
600
-6 -4 -2 0 2 4 6
Series: Standardized Residuals
Sample 3 2378
Observations 2376
Mean 0.009750
Median -0.050999
Maximum 6.081587
Minimum -6.097107
Std. Dev. 1.000536
Skewness 0.502920
Kurtosis 6.043210
J arque-Bera 1017.011
Probability 0.000000

Standardized residuals series is leptokurtosis; right skewed and the probability
associated to Jarque-Bera test rejects the hypothesis of a normal distributed series.
7
.000
.005
.010
.015
.020
.025
.030
500 1000 1500 2000
Conditional Standard Deviation


The equations of the model chosen are:
RON/EUR
t

= 0.0002400 + 0.0519310 RON/EUR
t-1
mean equation

RON/EURt
= 2.89E-07 + ARCH (1) 0.136413 + GARCH (1) 0.870345 variance
equation.

Based on GARCH2 model RON/EUR exchange rate is forecasted, using a
dynamic procedure, and the outputs are the following:
8
-600
-400
-200
0
200
400
600
500 1000 1500 2000 2500 3000
DL_RON_EURF2
Forecast: DL_RON_EURF2
Actual: DL_RON_EUR
Forecast sample: 1 3000
Adjusted sample: 3 3000
Included observations: 2376
Root Mean Squared Error 0.006193
Mean Absolute Error 0.004257
Mean Abs. Percent Error 111.2995
Theil Inequality Coefficient 0.960920
Bias Proportion 0.000951
Variance Proportion 0.996308
Covariance Proportion 0.002741
0
10000
20000
30000
40000
50000
60000
500 1000 1500 2000 2500 3000
Forecast of Variance

As we can see volatility shocks are quite persistent and the forecasts of
conditional variance converge to the steady state quite slowly.
Volatility forecast methods are useful; but not always suitable. The reality shows
that, at least, in Romania the exchange rate is mainly influenced by news, investors
expectations and models based only on historical observations are not so reliable; this is
because history is not likely to happen in the next period based on past information and
the exchange rate evolution can be compared to a random walk model not a predefined
one.
9

PROPOSALS AND CONCLUSIONS

Forecasting exchange rate volatility is an important issue for many financial
market participants. In order to predict exchange rate volatility many econometric models
can be used. I sustained my empirical survey mainly on EViews models such as GARCH.
In this paper I tried to find a suitable model for exchange rate volatility forecast.
I relayed on RON/EUR daily exchange rate observations over January 1999 to the
15
th
of May 2008.
Stationary series and series distribution are two important things to be considered
when making a forecast; so the series were analyzed and finally the forecast was based on
first difference of RON/EUR logarithm series.
Different GARCH models were built up and the equations of the model chosen
are [according to Akaike info criterion value]:
RON/EUR
t

= 0.0002400 + 0.0519310 RON/EUR
t-1
mean equation

RON/EURt
= 2.89E-07 + ARCH (1) 0.136413 + GARCH (1) 0.870345 variance
equation.
All five models showed that exchange rate series is a volatile.
More complex empirical studies were carried on and recently Christopher J. Neely
and Paul A. Weller discovered that genetic programs can better predict exchange rate
volatility than any other applications or models.
Volatility forecast methods are useful; but not always suitable. The reality shows
that, at least, in Romania the exchange rate is mainly influenced by news, investors
expectations and models based only on historical observations are not so reliable; this is
because history is not likely to happen in the next period based on past information and
the exchange rate evolution can be compared to a random walk model not a predefined
one.
Variance forecast obtained shows that volatility shocks are quite persistent and the
forecasts of conditional variance converge to the steady state quite slowly.



10
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