Structural Change and Long Range Dependence in Volatility of Exchange Rates: Either, Neither or Both?

Abstract:     
In this paper we test for the existence of long memory and structural breaks in the realized variance process for the DM/US$ and Yen/US$ exchange rates. While long memory is evident in the actual processes, a structural break analysis reveals that this feature is partially explained by unaccounted changes in regime. We then compare the forecasting performance of Markov switching models with that of an ARFIMA model. The results indicate that neglecting the break process is not important for very short term forecasting, once it is allowed for a long memory component in the model, but that superior forecasts can be obtained at longer horizons by modelling both long memory and structural change.

Keywords: Long memory, structural change, forecasting

JEL Classification: C14, C22, C53, G10

Accepted Paper Series