A Utility Based Comparison of Some Models of Exchange Rate Volatility

Abstract:     
When estimates of variances are used to make asset allocation decisions, underestimates of population variances lead to lower expected utility than equivalent overestimates: a utility based criterion is asymmetric, unlike standard criteria such as mean squared error. To illustrate how to estimate a utility based criterion, we use five bilateral weekly dollar exchange rates, 1973-1989, and the corresponding pair of Eurodeposit rates. Of homoskedastic, GARCH, autoregressive and nonpararnetric models for the conditional variance of each exchange rate, GARCI-J models tend to produce the highest utility, on average. A mean squared error criterion also favors GARCH, but not as sharply.

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