Edited by Adrian R. Bell, Chris Brooks and Marcel Prokopczuk
Chapter 16: Econometric modeling of exchange rate volatility and jumps
Volatility measures the dispersion of asset price returns. Recognizing the importance of foreign exchange volatility for risk management and policy evaluation, academics, policymakers, regulators and market practitioners have long studied and estimated models of foreign exchange volatility and jumps. Financial economists have sought to understand and characterize foreign exchange volatility, because the volatility process tells us about how news affects asset prices, what information is important and how markets process that information. Policymakers are interested in measuring asset price volatility to learn about market expectations and uncertainty about policy. For example, one might think that a clear understanding of policy objectives and tools would tend to reduce market volatility, other things being equal. More practically, understanding and estimating asset price volatility is important for asset pricing, portfolio allocation and risk management. Traders and regulators must consider not only the expected return from their trading activity but also the trading strategy’s exposure to risk during periods of high volatility. Traders’ risk-adjusted performance depends upon the accuracy of their volatility predictions. Therefore, both traders and regulators use volatility predictions as inputs to models of risk management, such as value-at-risk (VaR).
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