A Utility Based Comparison of Some Models of Exchange Rate Volatility
Kenneth D. West
University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER)
Hali J. Edison
International Monetary Fund (IMF) - Research Department
Korea Development Institute (KDI) - Macroeconomic Policy Division
NBER Working Paper No. t0128
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.
Number of Pages in PDF File: 47
Date posted: December 28, 2006
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