erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

Can We Really Model Exchange Rate Dynamics?

Remzi Nekhili (Bilkent University)
Aslıhan Altay (Bilkent University)
Salih Selçuk Caner (Bilkent University)

Abstract  

This study compares the empirical distribution of exchange rate returns with the existing theoretical one derived from different continuous-time processes using high frequency data. According to previous empirical studies of exchange rate returns, first, the unconditional distribution of exchange rate returns is leptokurtic and exhibits fatter tails than would be expected from normal distribution. Second, exchange rate returns exhibit periods of turbulence as well as periods of tranquility that result in volatility clustering. Among others, these facts have led to the estimation of empirical models of exchange rate returns which allow for conditional heteroskedasticity based on the ARCH framework of Engle (1982) as well as GARCH and EGARCH generalizations suggested by Bollerslev (1986) and Nelson (1991) respectively. The class of parametric ARCH models is based on a density that provides flexibility to model fat-tailed and skewed distributions. This often leads to a complex formulation for the conditional distribution of the exchange rate returns and may even be such that it is hard to estimate the parameters of the model. This is particularly a problem for the estimation of continuous-time models with stochastic volatility using high frequency financial data. This study uses a variety of models to simulate the unconditional density of the exchange rates. The methodology starts with generating different densities of exchange rates following a martingale, a geometric Brownian motion and a jump-diffusion process of exchange rates using Monte Carlo simulations. The time-varying volatility is modelled as following both a GARCH and an EGARCH specification. Finally, the theoretical distributions are compared with the empirical distributions that consist of half-hourly U.S. Dollar/ DEM exchange rate returns for the period from January 1, 1996 to January 1, 1997.

Economic Research Center
Middle East Technical University
06531 Ankara Turkey
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e-mail: metuerc@metu.edu.tr