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MODELING THE VOLATILITY OF EXCHANGE RATE CURRENCY USING GARCH

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Author::
CHAIDO DRITSAKI
Department of Accounting and Finance, Western Macedonia University of Applied Sciences, Kila, Kozani, Greece

MODELING THE VOLATILITY OF EXCHANGE RATE

CURRENCY USING GARCH MODEL

ABSTRACT

In this paper, we study GARCH models with their modifications in order to study the volatility of
Euro/US dollar exchange rate. Given that there are ARCH effects on exchange rate returns
Euro/US dollar, we estimated ARCH(p), GARCH(p,q) and EGARCH(p,q) including these effects
on mean equation. These models were estimated with maximum likelihood method using the
following distributions: normal, t-student and generalized error distribution. The log likelihood
function was maximized using Marquardt’s algorithm (1963) in order to search for optimal
parameter of all models. The results showed that ARIMA(0,0,1)-EGARCH(1,1) model with
generalized error distribution is the best in order to describe exchange rate returns and also
captures the leverage effect. Finally, for the forecasting of ARIMA(0,0,1)-EGARCH(1,1) model
both the dynamic and static procedure is used. The static procedure provides better results on
the forecasting rather than the dynamic.

Keywords:
Keywords Exchange Rate, Volatility, ARIMA-GARCH Models, Forecasting
JEL Classification:
Classification C22, C32, C53

RIASSUNTO

Modelli di volatilità del tasso di cambio con l’utilizzo di un modello GARCH

In questo articolo viene esaminata la volatilità del tasso di cambio Euro/dollaro USA tramite un
modello GARCH. Accertato che ci sono degli effetti ARCH sul tasso di cambio Euro/dollaro USA,
sono state effettuate delle stime ARCH (p), GARCH (p,q) e EGARCH(p,q) includendo questi
effetti su un’equazione minima. Questi modelli sono stati stimati col metodo della massima
somiglianza utilizzando queste distribuzioni: normale, t-student e distribuzione generalizzata di
errore. La funzione logaritmica di verosomiglianza è stata massimizzata usando l’algoritmo di
Marquardt (1963), al fine di cercare dei parametri ottimali per tutti i modelli. I risultati hanno
evidenziato che il modello ARIMA (0,0,1)-EGARCH(1,1) con distribuzione generalizzata di

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210 C. Dritsaki

errore è la migliore per descrivere i rendimenti del tasso di cambio e cogliere gli effetti leva.
Infine, nell’utilizzo del modello di previsione ARIMA(0,0,1)-EGARCH(1,1) sono state usate sia la
procedura dinamica che quella statica. Quest’ultima ha fornito risultati migliori sulla previsione
rispetto a quella dinamica.

1. INTRODUCTION

Issues concerning exchange rate are of great interest to researchers in modern economic theory.
Foreign exchange rate is regarded as the value of a currency in relation to another currency and
is fluctuated in relation to the demand and supply of currencies. Exchange rate is of vital
importance in the volume of trade and investment and its volatility decreases the volume of
international trade as well as foreign investment. Also, it is used as a fundamental economic
variable taken into consideration by investors of foreign currency, exporters and governments
for policy making. It is well known that exchange rate is under the authority of central banks in a
large extent, as well as under other financial institutions.

Modeling and forecasting of exchange rate has been widely discussed after the collapse of the
agreement for fixed currencies between industrial countries in the mid of 20th century – Bretton
Woods agreement. Thus, learning about currency volatility contributes in designing new
strategies about investment formulation.

The volatility on exchange rates influences the competitiveness of exports and imports, debt
payments of countries, as well as international investment portfolios. Moreover, the volatility of
exchange rates has impact on business economic cycles and capital flows, determining trade
terms with other countries thus directing the economic life of each country. The volatility of
exchange rate can also have consequences on international trade and influence balance of
payments of a country as well as government policy making. Consequently, forecasting the
volatility of exchange rate is of great importance for various groups, including the market and
also the decision makers.

During the last decades there has been an extended discussion as far as the exchange rate
volatility is concerned. As a consequence, several models have been developed in order to
examine this volatility. The models that are often applied in measuring the instability of
exchange rates are Autoregressive Conditional Heteroskedasticity-ARCH developed by Engle

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 Modeling the volatility of exchange rate currency using GARCH model 211

(1982) and Generalised ARCH-GARCH models developed by Bollerslev (1986) and Taylor (1986)
respectively.

This paper tries to develop and examine the characteristics of exchange rate volatility on
Euro/US dollar using monthly data from August 1953 until January 2017. The remainder of the
paper is organized as follows: Section 2 provides a brief literature review. Section 3 presents the
analysis of methodology. Section 4 summarizes the data and the descriptive statistics. The
empirical results are provided in Section 5 and Section 6 proposes the forecasting results.
Finally, the last section offers the concluding remarks.

2. LITERATURE REVIEW

After the collapse of the agreement of fixed currencies, exchange rate is a significant issue to
analyze, as its impact to countries’ trade balance, price levels and output is quite important.
Given its role to economy, many researchers focus on the forecasting of exchange rates both on
developed and developing countries using various methodologies, not only in a fundamental but
also in a technical level.

The ARCH model for the exchange rate was first applied by Hsieh (1988) in order to examine
daily data for five exchange rates. The results of his research support the view that if there is not
a linear correlation on data but a non-linear, then the model’s form is multiplicative and not
additive. So, he concludes that the generalized ARCH model (GARCH) can explain one part of
the non-linearity of exchange rates.

Most scientists paid more attention on bilateral exchange rates such as the paper of Mundaca
(1991), Johnston and Scott (2000), Yoon and Lee (2008), Abdalla (2012) and others.

During last years, many researchers have dealt with the forecasting of exchange rate volatility
both on developed and emerging markets such as Sandoval (2006), Vee et al. (2011), Antonakakis
and Darby (2012), Miletic (2015), Epaphra (2017) and others. Specifically, Sandoval (2006)
examined the exchange rates of seven countries in Asia and Latin America regarding the US
dollar. Using GARCH, GJR-GARCH and EGARCH he found that four out of seven exchange rates
that follow asymmetric models are included in developed countries. Furthermore, forecasting
on symmetric models showed better results than that of asymmetric models.

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212 C. Dritsaki

Vee et al. (2011) studied the forecast of exchange rate volatility of US Dollar/Mauritian Rupee.
For the estimation they used daily data from the period 30 June 2003 until 31 March 2008 and
the symmetric GARCH(1,1) model with Generalized Error Distribution (GED) and the
Student’s-t distribution. The results of their paper showed that Generalized Error Distribution
(GED) gives better results for exchange rate out-of-sample forecasts.

Antonakakis and Darby (2012) examine daily data from November 8, 1993 until December 29,
2000 for four exchange rates against the US dollar, such as the Botswana pula (BWP), Chilean
peso (CLP), Cyprus pound (CYP) and Mauritius rupee (MUR). Applying ARCH, GARCH,
EGARCH, IGARCH, FIGARCH and the HYGARCH models, they conclude that the IGARCH
model gives better results for out-of-sample forecast for all the examined exchange rates.

Miletić (2015) in his paper examines the hypothesis which refers that the exchange rate in
emerging markets is more sensitive in negative crises than positive ones. In order to study the
involved risk, he used daily data of exchange rate for the currencies of Hungary, Romania, Serbia,
Great Britain, Japan and European Union against US dollar, as well as the symmetric and non-
symmetric GARCH models. The results of forecast showed that the symmetric models, both on
developed and emerging markets (except the rate of Romania), have better return on the
exchange rates of all examined currencies.

Finally, Epaphra (2017) in his paper uses non-linear series for the forecasting of daily data on the
exchange rate of Tanzania (TZS/USD) from 4 January 2009 until 27 July 2015. Using the
symmetric GARCH model and the asymmetric EGARCH model, he concludes that the
symmetric GARCH model gives better results on forecasting but the asymmetric EGARCH
presents leverage effect implying a higher next period conditional variance than negative shocks
of the same sign.

3. THEORETICAL BACKGROUND

Taking into account the papers of Mandelbrot (1963), Fama (1965) and Black (1976), many
researchers found that the characteristics of exchange rate returns follow a non-linear time
dependence, while according to Friedman and Vandersteel (1982), the percentage of exchange
rate follow a leptokurtic distribution. Moreover, in their papers argue that small and big

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 Modeling the volatility of exchange rate currency using GARCH model 213

variances on exchange rates returns are clustered during time and are distributed symmetrically
with fat tails. The characteristics of these data follow the normal distribution and are included in
an ARCH model, introduced by Engle (1982) or in a GARCH model developed by Bollerslev
(1986).
While GARCH models can isolate the excessive kurtosis on returns, they cannot deal with the
asymmetry of distribution. To cope with this problem, researchers made modifications on
GARCH model, taking into account distributions’ asymmetry. Exponential GARCH (EGARCH)
is considered a non-linear model that deals with asymmetry and is developed by Nelson (1991).

3.1 ARIMA Model

ARIMA is one of the type of models in the Box-Jenkins methodology. Box-Jenkins (1976)
approach on time-series analysis is a methodology where we try to find an ARIMA(p,d,q) model
which best describes the stochastic process where the sample is derived. The methodology
consists of four stages, the model identification, estimation, diagnostic testing and finally
forecasting. In the first stage of identification, data are transformed in order to have a stationary
series. The process of stationarity is the foundation in formulating an ARIMA(p,d,q) model. The
ARIMA (p,d,q) can be expressed as:

ϕ p (L )(1 − L )d ( yt − µ ) = ϑq (L )et (1)

where
p q
ϕ p (L ) = 1 − ∑ ϕi Li and ϑq (L ) = 1 − ∑ϑ j L j are polynomials in terms of L of degree p and q.
i =1 j =1

yt is the time series, and et is the random error at time period t, with µ is the mean of the
model.
d is the order of the difference operator.
ϕ1 ,ϕ2 ,...,ϕ p and ϑ1 ,ϑ2 ,...,ϑq are the parameters of autoregressive and moving average terms
with order p and q respectively.
L is the difference operator defined as ∆yt = yt − yt −1 = (1 − L ) yt .

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214 C. Dritsaki

3.2 ARCH(p) Model

Engle (1982) developed the Autoregressive Conditional Heteroscedasticity (ARCH) model for
testing the volatility of financial series. The basic ARCH model consists of two equations, a
conditional mean equation and a conditional variance equation. Both equations should be
estimated simultaneously given that variance is a mean equation. The mean equation estimate
the conditional mean of the examined variable. The variance equation estimates this process as a
typical autoregressive process. Both equations form a system that is estimated together with
maximum likelihood method. So, ARCH model is an autoregressive process (AR) and can be
written as follows:

ε t = ztσ t where zt is white noise

p
σ t2 = ω + ∑αi ε t2−i (2)
i =1

where ω > 0 , α i ≥ 0 and i > 0 .

3.3 GARCH(p,q) Model

Bollerslev (1986) extended the ARCH model in a new one that allows the errors of variance to
depend on its own lags, as well as lags of the squared errors. In other words, it allows the
extension of conditional variance to follow an Auto Regressive Moving Average (ARMA) process.
The GARCH model can be expressed as:

ε t = ztσ t where zt is white noise

p q
σ t2 = ω + ∑α i ε t2−i + ∑ β j σ t2− j (3)
i =1 j =1

We assume that for every p ≥ 0 and q > 0 , the parameters are unknown and since the variance

is positive, then the following relations must be positive too ω ≥ 0 , and α i ≥ 0 for every i=1,…,q
p q
and β j ≥ 0 for j=1,…,p. If the parameters are constrained such that ∑ α i + ∑ β j < 1 , they imply a
i =1 j =1

weak stationarity. If q = 0 , then GARCH model is becoming an ARCH model.

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 Modeling the volatility of exchange rate currency using GARCH model 215

3.4 EGARCH(p,q) Model

The ARCH/GARCH models analyzed previously, focus mainly on the size of conditional variance
on the returns of exchange rate and ignore information about the direction, if it is positive or
negative. So, these models do not explain the leverage effect presented in time series. For testing
this asymmetric volatility, various models have been developed. The EGARCH model is regarded
one of these models that captures asymmetric responses of varying variance to shocks at the
same time keeps the variance positive. The EGARCH model developed by Nelson (1991) can be
expressed as:
ε t = ztσ t where zt is white noise
p
ε t −i q r
ε
log σ t2 = ω + ∑ α i + ∑ β j log σ t2− j + ∑ γ k t −k (4)
i =1 σ t −i j =1 k =1 σ t −k

where σ t is the conditional variance,

2
ω , α i , β j , and γ k are parameters to be estimated. On
parameters ω , α i and γ k there are no restrictions. However, the parameter β j should be
positive and less than 1 in order to have stationarity. Moreover, γ k parameter is an indicator of

leverage effect meaning asymmetry and must be negative and statistically significant.

3.5 Estimation of the GARCH Model

For the estimation of GARCH models, the maximum likelihood method is used. This method
enables the rates of return and variance to be jointly estimated. Parameters’ estimation on
logarithmic function of maximum likelihood are obtained through nonlinear least squares using
Marquardt’s algorithm (1963). The logarithmic function of maximum likelihood is computed
from the conditional densities of the prediction errors and is provided in the following form:


[ 
]
T
ln L[( yt ),θ ] = ∑ ln[D( zt (θ ),υ )] − ln σ t2 (θ ) 
1
(5)
t =1  2 
where θ is the vector of the parameters that have to be estimated for the conditional mean,

conditional variance and density function, zt denoting their density function, D( zt (θ ),υ ) , is

the log-likelihood function of [ yt (θ )] , for a sample of T observation. The maximum likelihood

estimator θˆ for the true parameter vector is found by maximizing (5) (see Dritsaki, 2017).

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216 C. Dritsaki

3.5.1 Conditional Distributions

Logarithmic function of maximum likelihood used for parameters’ estimation on volatility

models for all theoretical distributions are the following (see Dritsaki, 2017 :
• Normal distribution

1 T T

ln L[( yt ),θ ] = − T ln(2π ) + ∑ zt2 + ∑ ln(σ t2 ) (6)
2 t =1 t =1 
where θ is the vector of the parameters that have to be estimated for the conditional mean,
conditional variance and density function, T is observations.
• Student-t distribution

 υ +1  υ  1  1 T  z2  
ln L[( y t ),θ ] = Tln Γ  − ln Γ  − ln[π (υ − 2)] − ∑ ln(σ t ) + (1 + υ )ln 1 + t 
2
(7)
  2  2 2  2 t=1   υ − 2 
where
∞
Γ(υ ) = ∫ e−x xυ−1dx is the gamma function and υ is the degree of freedom.
0

• Generalized error distribution

T  υ
 υ  1 zt 
ln L[( yt ),θ ] = ∑ ln  − ( ) 1 1
( )
− 1 + υ −1 ln(2) − ln Γ  − ln σ t2 (8)
 λ  2 λ
t =1  υ  2 
where
1/ 2
  1 
 Γ  
λ =  2 −2 / υ υ 
 3
Γ  
  υ  

3.6 Diagnostic Checking of the ARIMA-GARCH Model

The diagnostic tests of ARIMA-GARCH models are based on residuals. Residuals’ normality test
is employed with Jarque-Bera (1980) test. Ljung and Box (1978) (Q-statistics) statistic for all
time lags of autocorrelation is used for the serial correlation test. Also, for the conditional
heteroscedasticity test we use the squared residuals of autocorrelation function.

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 Modeling the volatility of exchange rate currency using GARCH model 217

3.7 Forecast Evaluation

On ARIMA-GARCH models, we use both the static and dynamic forecast. The dynamic forecast
is known as n-step ahead forecast and uses the actual lagged value of Y variable in order to
calculate the first forecasted value. The one-step ahead forecast of Yt +1 based on an ARIMA-

GARCH model is defined as:

Yˆt (1) = Ε(Yt +1 Yt , Yt −1 ,...) = φ0 + ∑ φiYt +1−i + ∑ θ j ε t +1− j

p q
(9)
i =1 j =1

where the ε s follow the stated GARCH model.

For the evaluation of effectiveness on forecasting, we use two statistical measures namely Mean
squared error (MSE) and Mean absolute error (MAE).
Mean squared error (MSE) computes the squared difference between every forecasted value and
every realized value of the quantity being estimated, and finds the mean of them afterwards.
Mean squared error (MSE) has the following formula:

MSE =
1 n
n i =1
(
∑ Yi − Yˆi )
2
(10)

where
Yi is the vector of observed values of the variable being predicted.

Yˆi is the vector of n predictions.

Mean absolute error (MAE) computes the mean of all the absolute, instead of squared, forecast
errors. The formula is the following:
1 n
MAE = ∑ Yi − Yˆi
n i =1
(11)

4. DATA

The data used on this model of exchange rate return are monthly and refer to the Euro/US dollar
exchange rate. The data span is from August 1953 until January 2017, a total of 763 observations.
All data come from http://fxtop.com/en/historical-exchange-rates.php. Monthly percentage
return of exchange rate is the first difference from natural logarithm of exchange rate and is
given from the following equation:

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218 C. Dritsaki

 X 
Rt = 100* ln t  = 100*[ln( X t ) − ln( X t −1 )] (12)
 X t −1 
where

Rt is the monthly percentage return to the exchange rate;

X t is the exchange rate at time t.

The average monthly values of exchange rates and their returns are presented in diagrams 1 and
2 respectively.

DIAGRAM 1 - Average Monthly Values of Exchange Rates of the Euro/US dollar

From diagram 1, we can see that average monthly values of the exchange rate of Euro/US dollar
present a random walk.

DIAGRAM 2 - Average Monthly Values of Return of The Exchange Rate of the Euro/US dollar

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 Modeling the volatility of exchange rate currency using GARCH model 219

From diagram 2 we can see that average monthly values of the Euro/US dollar exchange rate are
stationary. Also, the variance seems to be unstable, thus we conclude that the exchange rate
returns show volatility.
For autocorrelation test on average monthly returns of Euro/US dollar, we use autocorrelation
coefficients, as well as partial autocorrelation coefficients. Autocorrelation function defines the
q rank of Moving Average model – MA(q) while partial autocorrelation function defines p rank
of autocorrelation model – AR(p). The graph of autocorrelation coefficients is the correlogram.
Also, for autocorrelation testing on average monthly returns of Euro/US dollar, we use the
Ljung-Box test (1978), which is presented on the following relationship:
m
 ρˆ 2 
QLB = n(n + 2)∑  k  ∼ χ2m (13)
k =1  n − k 

Following Tables 1 and 2 present the correlograms and we test if there is autocorrelation on
average monthly returns of Euro/US dollar, as well as the ARCH effect, on the correlogram of
average square monthly returns.

TABLE 1 - Correlogram of Average Monthly Returns of the Exchange Rate Euro/US dollar

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220 C. Dritsaki

From the results of Table 1 we point out that the Ljung-Box statistic (Q-statistics) for all time
lags of autocorrelation function are statistically significant meaning that there is serial
correlation on the average monthly returns of the exchange rate Euro/US dollar. Furthermore,
partial autocorrelation coefficients show a long run dependence among data (time lags of high
order). This result, according to Bollerslev (1986), features GARCH models as the most suitable
for the data of the Euro/US dollar exchange rate.

TABLE 2 - Correlogram of Average Square Monthly Return of Euro/US dollar

The results of Table 2 show that Ljung-Box (1978) statistic (Q-statistics) for all time lags of
square residuals of autocorrelation function are statistically significant, thus there is an ARCH
effect on the return of Euro/US dollar exchange rate.
Continuing, the descriptive statistics of the return on Euro/US dollar exchange rate are
presented.

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 Modeling the volatility of exchange rate currency using GARCH model 221

TABLE 3 - Descriptive Statistics of Average Monthly Return on the

Euro/US dollar Exchange Rate

Euro/
Euro/US dollar
Mean 0.003742
Median 0.001572
Maximum 6.812899
Minimum -8.143697
Std. Dev. 2.116776
Skewness -0.017459
Kurtosis 4.385232
Jarque-Bera 60.96277
Probability 0.0000
Observations 762

The results of Table 3 show that average monthly returns of the Euro/US dollar exchange rate do
not follow the normal distribution. Also, asymmetry’s coefficient shows that the distribution of
exchange rate returns is left asymmetric (-0.017), is leptokurtic (k=4.385), and has heavy tails
(see Diagram 3).

DIAGRAM 3 - Normal Density Graphs of the Average Monthly Return of the

Euro/ US dollar Exchange Rate

Continued, we test the stationarity of the average monthly returns of the Euro/ US dollar
exchange rate using Dickey-Fuller (1979, 1981) and Phillips-Perron (1998) tests.

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222 C. Dritsaki

TABLE 4 - Stationarity Test of Average Monthly Returns of the Euro/ US dollar Exchange Rate

Variable ADF P-P

C C,T C C,T
REURUS -19.946(0)* -19.933(0)* -20.016[1]* -20.004[1]*

Notes:
1. *, ** and *** show significant at 1%, 5% and 10% levels respectively.
2. The numbers within parentheses followed by ADF statistics represent the lag length of the
dependent variable used to obtain white noise residuals.
3. The lag lengths for ADF equation were selected using Schwarz Information Criterion (SIC).
4. Mackinnon (1996) critical value for rejection of hypothesis of unit root applied.
5. The numbers within brackets followed by PP statistics represent the bandwidth selected based on
Newey West (1994) method using Bartlett Kernel.
6. C=Constant, T=Trend.

The results in Table 4 show that the average monthly returns of the Euro/US dollar are
stationary in their levels on both tests.
After detecting stationarity, we determine the form of the ARMA(p,q) from the correlogram of
Table 1. Parameters p and q can be defined from partial autocorrelation coefficients and
autocorrelation coefficients, respectively, compared to the critical value
2 2
± =± = ±0.072 . Therefore, we can see that p value is between 0 ≤ p ≤ 1 and q value
n 762
is between 0 ≤ q ≤ 1 .

So, Table 5 provides with the following values:

TABLE 5 -Model Comparison between AIC, SIC and HQ Tests

ARIMA model AIC SC HQ

REURUS
( 0,0,1
,0, 1) 4.232
4. 232 4.244
4. 244 4.236
4. 236
(1,0,0) 4.239 4.251 4.244
(1,0,1) 4.234 4.252 4.241

The results from the above Table indicate that according to Akaike (AIC), Schwartz (SIC) and
Hannan-Quinn (HQ) criteria, ARIMA (0,0,1) model is the most suitable, as far as the mean
monthly returns for the Euro/US dollar is concerned.

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 Modeling the volatility of exchange rate currency using GARCH model 223

TABLE 6 - Estimation of ARIMA(0,0,1) Model

After the estimation of the above model, we test for the existence of conditional
heteroscedasticity (ARCH(p) test) from the squared residuals of the above model. Table 7 gives
these results.
TABLE 7 - ARCH(p) Test

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224 C. Dritsaki

From the results of the above Table, we conclude that autocorrelation and partial
autocorrelation coefficients are statistically significant. Consequently, the null hypothesis for
the absence of ARCH or GARCH procedure is rejected.

5. EMPIRICAL RESULTS

Since there are ARCH effects on the returns of the Euro/US dollar exchange rate, we can proceed
with the estimation of ARCH(p), GARCH(p,q) and EGARCH(p,q) models. The estimation of the
parameters is accomplised using Marquardt’s algorithm (1963). The parameters (coefficients) of
estimated models and the test of normality, autocorrelation and conditional heteroskedasticity
of the residuals are provided in Table 8. A higher log-likelihood value (LL) yields a better fit.

Table 8 provides the estimations of all models and the standard errors of the parameters
(coefficients) together with the value of log-likelihood function, as well as the normality test,
autocorrelation test and conditional heteroskedasticity test. From the Table below we can see
that the ARIMA(0,0,1)-EGARCH(1,1) model with the generalized error distribution (GED) is the
most suitable because all the coefficients are statistically significant in 1% level of significance,
the log-likelihood value is the highest and there is no problem in autocorrelation and the
conditional heteroscedasticity. In addition, β1 coefficient is positive and less than one showing
the stationarity of the model. Also, γ1 coefficient is negative and statistically significant
indicating leverage result (asymmetry). Thus, this model can be used for forecasting.

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 Modeling the volatility of exchange rate currency using GARCH model 225

TABLE 8 - Estimated ARIMA(0,0,1)-ARCH(1), ARIMA(0,0,1)-GARCH(1,1),

ARIMA(0,0,1)-EGARCH(1,1)

ARIMA(0,0,1)-
ARIMA(0,0,1) -ARCH(1)
Parameter Normal t-Student GED
ω 3.327(0.000) 1.059(0.999) 0.165(0.000)
α1 0.198(0.000) 0.492(0.999) 1.436(0.000)
D.O.F=2.001(0.000) PAR=0.403(0.000)
LL -1604.01 -1352.00 -1346
1346.
46. 87
Jarque-Bera 136.12(0.000) 1368.25(0.000) 3198(0.000)
ARCH(1) 1.450(0.228) 0.163(0.685) 0.623(0.429)
Q2( 10) 10.364(0.322) 2.655(0.976) 5.910(0.749)
ARIMA(0,0,1)-
ARIMA(0,0,1) -GARCH(1,1)
Parameter Normal t-Student GED
ω 0.012(0.000) 0.001(0.161) 0.003(0.000)
α1 0.081(0.000) 0.434(0.107) 0.748(0.000)
β1 0.923(0.000) 0.560(0.000) 0.664(0.000)
D.O.F=2.246(0.000) PAR=0.656(0.000)
LL -1385.388 -1136.38 -1184
1184. 66
Jarque-Bera 31749.92(0.000) 6812.99(0.000) 6097.4(0.000)
ARCH(1) 0.479(0.488) 0.025(0.873) 0.003(0.951)
Q2( 10) 0.482(0.487) 0.082(0.344) 0.082(0.997)
ARIMA(0,0,1)-
ARIMA(0,0,1) -EGARCH(1,1)
Parameter Normal t-Student GED
ω 0.010(0.000) 0.001(0.166) -0.003(0.000)
α1 0.099(0.000) 0.159(0.120) 0.178(0.000)
β1 0.923(0.000) 0.564(0.000) 0.666(0.000)
γ1 -0.059(0.235) -0.403(0.543) -0.082(0.000)
D.O.F=2.243(0.000) PAR=0.655(0.000)
LL -1380.42 -1136.18 -1174
1174.
74. 77
Jarque-Bera 6269.45 (0.000) 5940.12(0.000) 1597(0.000)
ARCH(1) 0.012(0.910) 0.003(0.981) 0.011(0.916)
Q2( 10) 9.164(0.422) 1.379(0.992) 1.568(0.997)

Notes:
1.Values in parentheses denote the p-values.
2.LL is the value of the log-likelihood.

6. FORECASTING

For the forecasting of ARIMA(0,0,1)-EGARCH(1,1) model on the returns of Euro/US dollar

exchange rate, we use both the dynamic (n-step ahead forecasts) and static (one step-ahead
forecast) procedure. The dynamic procedure computes forecasting for periods after the first

ECONOMIA INTERNAZIONALE / INTERNATIONAL ECONOMICS 2019 Volume 72, Issue 2 – May, 209-230
226 C. Dritsaki

sample period, using the former fitted values from the lags of dependent variable and ARMA
terms. The static procedure uses actual values of the dependent variable. In the following
diagram, we present the criteria for the evaluation of forecasting the returns of Euro/US dollar
exchange rate, using the dynamic and static forecast respectively.

DIAGRAM 4 - Dynamic and Static Forecast of Euro/US dollar

The above diagram indicates that the static procedure gives better results rather than the
dynamic (Mean Squared Error and Mean Absolute Error are lower in the static rather than the
dynamic process).

7. DISCUSSION AND CONCLUSION

This paper focuses on the formation of a model for the Euro/US dollar exchange rate. Due to the
fact that exchange rate is regarded as a financial time series that may present volatility, it is more
suitable to use models from GARCH family. More specific, the non-linear ARIMA(0,0,1)-
ARCH(1), ARIMA(0,0,1)-GARCH(1,1) and ARIMA(0,0,1)-EGARCH(1,1) models were used in
order to register the volatility of exchange rate. Furthermore, the leverage effect is captured
from the estimation of ARIMA(0,0,1)-EGARCH(1,1) model, showing that positive shocks cause
lower volatility in relation to negative ones. Finally, the forecast of ARIMA(0,0,1)-EGARCH(1,1)
model is evaluated, using both the dynamic and static procedure.

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 Modeling the volatility of exchange rate currency using GARCH model 227

So, economic policy makers should forecast the future values of exchange rates using the
equivalent models. The instability of exchange rate is an uncertainty measure in an economic
environment for each country that should be forecasted. The main policy implication from the
results of this paper is that since exchange rate instability may increase transaction costs and
reduce the gains to international trade, the insight of exchange rate volatility estimation and
forecasting is important for asset pricing and risk management.

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