Conditional Volatility of Exchange Rates Under a Target Zone

24 Pages Posted: 12 May 1997

See all articles by Yin-Feng Gau

Yin-Feng Gau

National Central University

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Abstract

To study the impact of institutional features of target zones on the conditional volatility of exchange rates, this paper proposes a simple and intuitive model to incorporate the announced information in the bands. Observing the statistical characteristics of the EMS cross rate returns- mean reversion and heteroskedasticity, we t a GARCH(1,1)- MA(1) speci cation incorporating the deviation of exchange rates from the central parity. This model allows us to easily examine the relationship between the conditional volatility and the position of spot rates. We nd in particular, that for the Irish punt and Italian lira DM rates, the conditional volatility increases as the exchange rate approaches the edges of the band. We extend the above univariate model to a multivariate setting to take account of the cross country interactions in the EMS, by including a vector consisting of all EMS currencies' positions in the GARCH equation. The estimation results show that other currencies' positions do a ect the conditional volatility of a speci c EMS currency. Understanding the importance of intra-ERM coherence and the multilateral commitment on the central parity, we follow Pill(1994) to derive an \e ective band" model to examine how the multilateral grid affects the conditional volatility. However, the estimation results suggest that the full set of all deviations from ocial central parity of each member country explains the volatility better than does simply the deviation from the effective band.

JEL Classification: F31, C32

Suggested Citation

Gau, Yin-Feng and Engle, Robert F., Conditional Volatility of Exchange Rates Under a Target Zone. Available at SSRN: https://ssrn.com/abstract=39724 or http://dx.doi.org/10.2139/ssrn.39724

Yin-Feng Gau

National Central University ( email )

No. 300, Jhongda Rd, Jhogli City, Taoyuan, Taiwan,
Jhongli, TY 32001
Taiwan

Robert F. Engle (Contact Author)

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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