On the Predictive Power of the Spread Between Spot and Forward Exchange Rates for Volatility

Tae Hwy Lee

Korean Economic Review, 1992, vol. 8, 99-115

Abstract: This paper is concerned with modeling the conditional heteroskedasticity of the prediction error of foreign exchange rates with a function of the spread between spot and forward rates. As spot and forward rates are cointegrated we use a system of error correction models (ECM) for mean prediction. To predict variance we use an extended bivariate generalized autoregressive conditional heteroskedasticity (GARCH) as a function of the spread. The model will be referred to as GARCH-X in ECM. Using daily series for seven currencies, we find that unmodeled conditional heteroskedasticity by GARCH can generally be explained by the squared spread. This indicates that as the spread is bigger the exchange rates are more volatile.

Date: 1992
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