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Using Exchange-Rate Volatility in a GARCH Return Model

Article Quant Q&A · Author: James Mark Gbeda
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Summary

The document asks whether a standard-deviation measure of exchange-rate volatility can be included as a regressor in the mean or variance equation of a GARCH or EGARCH model for stock returns. The response says it can, on the grounds that GARCH models account for time-varying conditional variance and volatility dynamics.

The answer is brief and does not specify how exchange-rate volatility should be constructed, aligned in time, or tested in either equation. It also does not distinguish the interpretation of a mean-equation effect from a variance-equation effect, or address model diagnostics, endogeneity, or whether an estimated relationship improves forecasts. Thus, it provides a broad modeling possibility rather than a complete specification or empirical result. Researchers would need to define the volatility measure and assess the chosen model on their data.

Key ideas

  • A measure of exchange-rate volatility may be considered as a regressor in a GARCH-family model of stock returns.
  • The proposed placement is either the conditional mean equation or the conditional variance equation.
  • GARCH models represent conditional heteroskedasticity and evolving volatility.
  • The response does not provide a specification or empirical checks for the proposed regressor.

Tags

ForexEquitiesVolatilityStatistics
Full text
# GARCH Model Estimation with Standard Deviation


# GARCH Model Estimation with Standard Deviation












I want to examine exchange rate volatility on Stock Returns. Please, if I Generate Exchange rate volatility (ER_vol)using standard deviations approach, can I include the (ER_vol) as a regressor in the Mean or Variance equation of the GARCH/EGARCH model?

## Answer by Gogo78 (score 1)

https://quant.stackexchange.com/a/50580

Yes, because GARCH is taking in account for characteristics of exchange rate volatility such as dynamics of conditional heteroscedasticity.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.