Alexandria Engineering Journal (2022) 61, 9601–9608

H O S T E D BY
Alexandria University

Alexandria Engineering Journal

www.elsevier.com/locate/aej
www.sciencedirect.com

The effects of incorporating memory and stochastic

volatility into GBM to forecast exchange rates of
Euro
Mohammed Alhagyan

Mathematics Department, College of Science and Humanities in Al Aflaj, Prince Sattam Bin Abdulaziz University, Al Kharj
11912, Saudi Arabia

Received 26 January 2021; revised 20 February 2022; accepted 15 March 2022

KEYWORDS Abstract The performance of financial trading in any country depends significantly on the role of
Exchange rates; exchange rate, specifically the activity of international trading. Thus, one of the priority of stake-
Geometric Brownian holders is knowing the direction of exchange rates in future. For this reason, many models in liter-
motion; ature are proposed. Geometric Brownian motion GBM model is one of them. This paper studies the
Geometric fractional Brow- affection of incorporating memories and stochastic volatility SV assumption on EUR by forecasting
nian motion; exchange rates of EUR/USD, EUR/SAR and EUR/AUD. The forecasting done depending on
Stochastic volatility; three models including GBM (no memory), geometric fractional Brownian motion GFBM (one
Fractional Orenstein- source of memory) and GFBM perturbed by SV that obeys fractional Orenstein-Uhlenbeck process
Uhlenbeck process (two sources of memory). The findings show that GFBM perturbed by SV has the best performance
according to the smallest value of mean square error MSE. This result shows the positive effects to
incorporate two sources of memory and SV assumption into GBM and thus it can apply in fore-
casting future prices of exchange rates of for EUR/SAR, EUR/USD and EUR/AUD.
Ó 2022 The Authors. Published by Elsevier B.V. on behalf of Faculty of Engineering, Alexandria
University This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/
licenses/by-nc-nd/4.0/).

1. Introduction take right decision. In literature, there are different models

proposed to forecast exchange rate such as random walk pro-
The performance of financial trading in any country depends cess, Brownian motion process, jump diffusion process, geo-
significantly on the role of exchange rates, specifically the metric Brownian motion (GBM). In this work, we will
activity of international trading. Exchange rates varies every discuss some GBM models.
day, and it is determined by selling and buying of foreign cur-
rencies on world currency market. Thus, it is very important to 1.1. Geometric Brownian motion
forecast the direction of exchange rates to help stakeholders to
In 1999, Ross [37] applied Brownian motion (BM) process for
E-mail address: m.alhagyan@psau.edu.sa modeling stock price directly. However, his work has been
Peer review under responsibility of Faculty of Engineering, Alexandria under heavy criticism since BM process also takes into consid-
University. eration of negative price because the price of a stock is
https://doi.org/10.1016/j.aej.2022.03.036
1110-0168 Ó 2022 The Authors. Published by Elsevier B.V. on behalf of Faculty of Engineering, Alexandria University
This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).
9602
assumed a normal random variable. To deal with this issue, a
geometric Brownian motion GBM (which is non–negative
variation of BM) was introduced to improve the application
of BM in finance. This new characteristic allows GBM to be
widely used in financial mathematics since it can describe the
real situation better as in the famous Black–Scholes model
and exchange rates. GBM model is defined as follow.
Model 1: A stochastic process St is said to follow a geometric
Brownian motion (GBM) if it satisfies the following stochastic
differential equation (SDE):
dSt ¼ lSt dt þ rSt dWt ð1Þ
where Wt is a BM, l is a drift and r is a volatility taking con-
stants values. The solution of Equation (1.1) is of the form.

 
1
St ¼ s0 exp l  r2 t þ rWt ð2Þ
2
where s0 is an arbitrary initial value [44].
Despite the improvement of this approach, several
researchers such as Painter [35], Willinger et al. [45], Grau–
Carles [21], Rejichi and Aloui [36], and recently Alhagyan
[4], Balabana and Lub [12], Kim et al. [28], and Han et al.
[23] to name just a few, argued that data of a time series gov-
erned by this model exhibited memory. Thus, the need to
develop a model of GBM that can incorporate with long mem-
ory properties started gearing up in the literature. Next subsec-
tion gives a brief review of long memory.
1.2. Long memory and fractional Brownian motion
Traditional financial modeling is based on semimartingale pro-
cesses with stationary and independent increments, meaning
that the process can be decomposed into a finite variation term
and a local martingale term, though practical examination of
financial data showed such assumption are contradictory.
Most of real data showed dependency better known as self–
similarity or long memory (long-range dependence). One of
the models proposed to handle this issue is Fractional Brown-
ian motion (FBM).
FBM is a continuous Gaussian process with independent
increments. The correlation between the increments of FBM
varies consistently with it self–similarity parameter or Hurst
parameter (H index) which helps to capture the correlation
dynamics of data and therefore should produce better forecast-
ing results. The name Hurst parameter, derives from Harold
Edwin Hurst (1880–1978), who studied Nile river’s volatile
rain and drought conditions that had been observed over a
long period of time.
We have three different families of memory dependence
according to the value of H. Short memory dependence if
0 < H < 0:5, no memory dependence if H ¼ 0:5 and long
memory dependence if 0:5 < H < 1.
Definition:. The fractional Brownian motion (FBM), {BH ðtÞ},
with Hurst parameter H 2 ð0; 1Þ is a centered Gaussian process
whose paths are continuous with probability 1 and its distribution
is defined by the covariance structure:
 
E½BH ðtÞBH ðsÞ ¼ 12 t2H þ s2H  jt  sj2H . [30].
Based on empirical studies, volatilities and returns of stock
prices habitually showed long memory property or long–range
M. Alhagyan
dependency. Such behavior is depicted in its autocovariance
function, in which the values at different times decay slowly.
Since FBM process can exhibit long memory phenomenon in
the data, thus, it is only natural to extend the traditional works
in financial modeling by adapting theoretical advantages of
such process.
A natural improvement of GBM model is GFBM model
which is obtained by replacing BM in the error term in
GBM model with FBM to incorporate memory properties to
GBM model as the following.
Model 2: A stochastic process S t is said to follow a geometric
fractional Brownian motion (GFBM) if it satisfies the following
stochastic differential equation (SDE):
dSt ¼ lSt dt þ rSt dBH1 ðtÞ ð3Þ
where BH1 ðtÞ is FBM,r and l are constants parameters that
represent volatility and drift respectively. The solution of
Equation (3) is of the form.


1
SðtÞ ¼ S0 exp l  r2 t2H1 1 t þ rBH1 ðtÞ ð4Þ
2
where s0 is an arbitrary initial value [14].
A GFBM model has important features as its parameters
(l; r and H1 ) are essential elements in many financial applica-
tions. For example pricing the option by using fractional
Black–Scholes model as works of Misiran et al. [32,33],
Kukush et al. [29], Alhagyan et al. [6,7] and Alhagyan [4], fore-
casting index prices [46], Alhagyan [4], Alhagyan & Al-Duais
[5] and Abbas & Alhagyan [1], determining value at risk [43],
Alhagyan [4] and Alhagyan et al. [10], identifying volatility
in exchange rate Gözgör [20], and determining premium in
mortgage insurance Bardhan et al. [13], Chen et al. [15], Alhag-
yan [4] and Alhagyan et al. [9]
1.3. Stochastic volatility
In the last few decades, volatility has been aggressively dis-
cussed in time series econometrics and economic forecasting.
In economics, volatility is used to describe variability of ran-
dom component of a time series. Financial economics defines
the volatility as the standard deviation of a random Wiener
driven component in a continuous time diffusion model.
The volatility of currencies and relative valuations always
have important reflects on overall economic performance, the
balance of payments and international trade [34]. Recently,
there are many scholars investigate empirically the effect of
stochastic volatility on exchange rate such as Gong and
Zhuang [19], Ahlip and Rutkowski [2], Alhagyan [4], Isering-
hausen [26].
Although many studies assumed the volatility r is constant
to simplicity of calculations, there are many empirical studies
such as; Bakshi et al. [11], Aїt–Sahalia and Lo [3], and Stein
[40] rejected this assumption because it cannot describe the real
situation accurately. There has been much effort to tackle this
issue by influencing the constant volatility in GBM model with
a stochastic volatility (SV). Among the effort includes works
carried out by Hull and White [25], Stein and Stein [39], Hes-
ton [24], Hagan et al. [22], Comte and Renault [17], Chrono-
poulou and Viens [16], and Wang and Zhang [42], Gatheral
et al. [18], Alhagyan et al. [7,6,8], Alhagyan [4], Iseringhausen
[26].
The effects of incorporating memory and stochastic volatility into GBM to forecast exchange rates of Euro
In general, a SV model is a statistical method that plays a
significant role in mathematical finance, which is substantial
for financial markets and decision making because they can
capture the effect of time–varying volatility. This model refers
to the volatility and common dependence between variables
that are permitted to fluctuate over time, instead of remaining
constant. Stochastic volatility (SV) models are considered the
most appropriate approaches to capture an implied volatility
smile and fat tailed distribution of asset price return [27]. Such
properties can significantly improve the pricing of asset under
the Black-Scholes model in addition to exchange rates. This
implies that SV model has two sources of randomness which
can either be correlated or not.
In SV model, the constant volatility r in Equations (1) and
(3) are replaced by a deterministic function of a stochastic pro-
cess or volatility process (rðYt Þ) where, Yt represents the solu-
tion of stochastic differential equation (SDE) that is driven by
other noise. Table 1 shows some popular SV models which
depend on the deterministic function rðÞ and the volatility
process Yt .
All SV models listed in Table 1 incorporated one source of
memory at most and no one of them deal with incorporating
two sources of memory. For more details see Alhagyan et al.
[8].
The downsides of the existing models inspired Alhagyan [4]
to treat the gap by extending the existing works to come up
with a model of GFBM having stochastic volatility. As a
result, the developed model is capable of describing and repre-
senting real life situations more accurately, particularly in
financial scenarios.
Model 3: A stochastic process S t is said to follow a geometric
fractional Brownian motion perturbed by stochastic volatility if
it satisfies the following stochastic differential equation:
dSt ¼ lSt dt þ rðYt ÞSt dBH1 ðtÞ ð5Þ
where l is mean of return, Yt is a stochastic process, BH1 ðtÞ is a
fractional Brownian motion (FBM) with Hurst index H1 , and
rðYt Þ ¼ Yt is a deterministic function.
Let the dynamics of volatility Yt be described by fractional
Ornstein–Uhlenbeck (FOU) process which is the solution of
the following stochastic differential equation.
dYt ¼ aðm  Yt Þdt þ bdBH2 ðtÞ ð6Þ
where a; b and m are constant parameters that represent mean
reverting of volatility, volatility of volatility, and mean of
Table 1 Popular SV models.
Model
Scott [38]
Hull and White [25]
Stein and Stein [39]
Heston [24]
Hagan et al. [22]
Vasicek [41]
Comte and Renault [17]
Mishura and Swishchuk [31]
Mishura and Swishchuk [31]
Mishura and Swishchuk [31]
Mishura and Swishchuk [31]
Chronopoulou and Viens [16]
9603
volatility, respectively. BH2 ðtÞ is another FBM which is inde-
pendent from BH1 ðtÞ. [4].
To recap, this research investigates the effects of incorpo-
rating both of memory and the assumption of stochastic
volatility into the classical GBM model. According to this
incorporating we will have three models; Model 1 without con-
sidering of memory nor stochastic volatility called classical
GBM, Model 2 with existence of memory and ignoring
stochastic volatility assumption called geometric fractional
Brownian motion (GFBM), and Model 3 with existence of
memory and considering of stochastic volatility assumption
called GFBM perturbed by stochastic volatility.
The effects of incorporating both memory and the assump-
tion of stochastic volatility into the classical GBM model will
appear empirically by comparing the performance of the three
previous models. To do this, the three models under study will
be used to forecast the exchange rate of the Euro in corre-
sponding to three currencies including Saudi Riyal (SAR),
United States Dollar (USD) and Australian Dollar (AUD).
2. Forecasting exchange rates
It is known that the volume of trading between Europe from
one side and United States of America, Saudi Arabia or Aus-
tralia from other side is huge. This encourages author to
choose currency pairs of EUR/USD, EUR/SAR and EUR/
AUD to be under study and investigation.
The author studies the effect of incorporate memories and
stochastic volatility on EUR by forecasting exchange rates of
EUR/USD, EUR/SAR and EUR/AUD using Model 1, Model
2 and Model 3 to exhibit the most appropriate model that can
used to help investors and stakeholders for avoiding losses and
achieving maximum profits as it possible.
2.1. Data and methodology
The historical data of EUR/SAR, EUR/USD and EUR/AUD
are available online at the website, https://www.ofx.com/. The
daily exchange rate from 1st October 2019 to 31st December
2019 are studied. This period interval is selected because the
appearance of long memory property. The return series are
calculated in logarithm (i.e rn1 ¼ ln ðsn =sn1 Þ to avoid high
volatility in the data. Figs. 1-6 show the exchange rates and
their return series.
rðÞ Yt
e y
dYt ¼ aðm  Yt Þdt þ bdW2t
pffiffiffi
y dYt ¼ aYt dt þ bYt dW2t
jyj dYt ¼ aðm  Yt Þdt þ bdW2t
pffiffiffi pffiffiffiffiffi
y dYt ¼ hðx  Yt Þdt þ n Yt dW2t
jyj dYt ¼ aYt dW2t
y dYt ¼ aðm  Yt Þdt þ bdW2t
y dYt ¼ aðm  Yt Þdt þ bdBH2 ðtÞ
y dYt ¼ aYt dt þ cYt dBH ðtÞ
y dYt ¼ aðb  Yt Þdt þ cYt dBH ðtÞ
pffiffiffi
y dYt ¼ aYt dt þ cYt dBH ðtÞ
pffiffiffi
y dYt ¼ aðb  Yt Þdt þ cYt dBH ðtÞ
y dYt ¼ aYt dt þ bdBH ðtÞ
9604 M. Alhagyan

Fig. 1 Historical exchange rates between EUR and USD.

Fig. 4 Daily returns series of exchange rate between EUR and
AUD.

Fig. 2 Daily returns series of exchange rate between EUR and

Fig. 5 Historical exchange rates between EUR and SAR.
USD.

Fig. 6 Daily returns series of exchange rate between EUR and

Fig. 3 Historical exchange rates between EUR and AUD. SAR.
The effects of incorporating memory and stochastic volatility into GBM to forecast exchange rates of Euro 9605

Table 2 Initial parameters obtained from daily index price data of last quarter of 2019.
H1 Hurst index H2 Hurst index lMean mMean of bVolatility of aMean S0 Initial
of price of volatility volatility volatility reverting price

EUR/SAR 0.58 0.6 0.0003 0.000005 0.000009 1.63 4.2077

EUR/USD 0.6 0.65 0.0003 0.000004 0.000009 1.63 0.8906
EUR/AUD 0.3 0.18 0.00025 0.000009 0.000013 3.15 1.5973
Note: One can observe that the values of initial parameters of EUR/SAR and EUR/USD are closed, while there are clear differences with EUR/
AUD. This refers to the fact that Saudi Riyal pegs to the US dollar, unlike the Australian dollar, which pegs to the basket of currencies.

computed volatility values are available in the following

Table 3 Volatility of each exchange rates.
Table 3.
Volatility type Model 1 Model 2 Model 3 Note that the constant volatility is computed by the tradi-
GBM GFBM GFBM with SV Pn  2
ðri ri Þ
tional formula of standard deviation r ¼ i¼1 n , while
EUR/SAR 0:0023 0:0023 0.000005
EUR/USD 0:0022 0:0022 0.000005 stochastic volatility is obtained by Equation (6).
EUR/AUD 0:003 0:003 0.000008 Next, to evaluate the exchange rates forecasting methods, we
applied the mean square error (MSE) formulation as follows:
Pn
The forecasting of the exchange rates of EUR/SAR, EUR/ ðsi  sbi_ Þ2
MSE ¼ i¼1 ð7Þ
USD and EUR/AUD for the first month of year 2020 are com- n
puted depending on the initial parameters that obtained from where si and sbi_ are actual and forecasted exchange at time
daily index price data of last quarter of 2019 as in Table 2 (day) i respectively.
below. The calculations of the parameters were done according
to some commands in Mathematica 10 software. 2.2. Results
The forecasted exchange rates values are computed by
using GBM with constant volatility assumption (Model 1),
Tables 4–6 show the forecasted values of EUR/SAR, EUR/
GFBM with constant volatility assumption (Model 2), and
USD and EUR/AUD exchange rates respectively via three
GFBM with stochastic volatility assumption (Model 3). The

Table 4 Actual and forecasted prices of EUR/SAR. Table 5 Actual and forecasted prices of EUR/USD.
Date Exact Model 1 Model 2 Model 3 Date Exact Model 1 Model 2 Model 3
Jan 01, 20 4.191475 4.21059 4.20897 4.20897 Jan 01, 20 0.895 0.8901 0.888901 0.89034
Jan 02, 20 4.190198 4.22019 4.20899 4.20899 Jan 02, 20 0.89523 0.888969 0.890212 0.890343
Jan 03, 20 4.192931 4.2069 4.20896 4.20896 Jan 03, 20 0.8949 0.890151 0.889054 0.89034
Jan 04, 20 4.187025 4.2132 4.20897 4.20897 Jan 04, 20 0.896098 0.891806 0.890953 0.890344
Jan 05, 20 4.187025 4.20967 4.20896 4.20896 Jan 05, 20 0.896098 0.888963 0.892611 0.890348
Jan 06, 20 4.196894 4.22019 4.20899 4.20899 Jan 06, 20 0.89392 0.89073 0.892505 0.890347
Jan 07, 20 4.178037 4.20113 4.20895 4.20895 Jan 07, 20 0.89792 0.890426 0.891102 0.890344
Jan 08, 20 4.169298 4.21419 4.20897 4.20897 Jan 08, 20 0.89972 0.887843 0.890244 0.890343
Jan 09, 20 4.165508 4.20713 4.20896 4.20896 Jan 09, 20 0.90063 0.892693 0.891317 0.890345
Jan 10, 20 4.170978 4.22291 4.20899 4.20899 Jan 10, 20 0.89947 0.889782 0.893712 0.89035
Jan 13, 20 4.178835 4.19912 4.20894 4.20894 Jan 13, 20 0.89781 0.888483 0.893027 0.890349
Jan 14, 20 4.175628 4.21091 4.20897 4.20897 Jan 14, 20 0.89851 0.892302 0.891561 0.890345
Jan 15, 20 4.186149 4.21387 4.20897 4.20897 Jan 15, 20 0.89617 0.890096 0.886821 0.890335
Jan 16, 20 4.175981 4.21239 4.20897 4.20897 Jan 16, 20 0.898285 0.891182 0.893633 0.89035
Jan 17, 20 4.161385 4.20647 4.20896 4.20896 Jan 17, 20 0.901455 0.892104 0.892955 0.890348
Jan 18, 20 4.160806 4.19407 4.20893 4.20893 Jan 18, 20 0.901648 0.892962 0.894303 0.890351
Jan 19, 20 4.160806 4.20614 4.20896 4.20896 Jan 19, 20 0.901648 0.889817 0.891989 0.890346
Jan 20, 20 4.158701 4.22144 4.20899 4.20899 Jan 20, 20 0.90217 0.889991 0.891757 0.890346
Jan 21, 20 4.163261 4.18899 4.20892 4.20892 Jan 21, 20 0.9012 0.887624 0.887732 0.890337
Jan 22, 20 4.158535 4.20636 4.20896 4.20896 Jan 22, 20 0.90214 0.889262 0.886371 0.890334
Jan 23, 20 4.14133 4.21582 4.20898 4.20898 Jan 23, 20 0.9058 0.89476 0.889058 0.89034
Jan 24, 20 4.136266 4.23096 4.20901 4.20901 Jan 24, 20 0.907 0.88909 0.889827 0.890342
Jan 25, 20 4.136262 4.21801 4.20898 4.20898 Jan 25, 20 0.906997 0.887335 0.885803 0.890333
Jan 26, 20 4.136262 4.2147 4.20897 4.20897 Jan 26, 20 0.906997 0.887841 0.889186 0.89034
Jan 27, 20 4.13409 4.20027 4.20894 4.20894 Jan 27, 20 0.90742 0.892056 0.888722 0.890339
Jan 28, 20 4.130425 4.21576 4.20898 4.20898 Jan 28, 20 0.908305 0.887569 0.890613 0.890343
Jan 29, 20 4.128324 4.19863 4.20894 4.20894 Jan 29, 20 0.90882 0.891348 0.889531 0.890341
Jan 30, 20 4.13799 4.20285 4.20895 4.20895 Jan 30, 20 0.90666 0.891191 0.888912 0.89034
MSE 0.002638 0.00259 0.00248 MSE 0.0001407 0.0001438 0.0001346
9606 M. Alhagyan

Table 6 Actual and forecasted prices of EUR/AUD.

Date Exact Model 1 Model 2 Model 3
Jan 01, 20 1.59072 1.59372 1.59596 1.59688
Jan 02, 20 1.60004 1.59543 1.58833 1.59686
Jan 03, 20 1.60507 1.58992 1.59817 1.59689
Jan 04, 20 1.60581 1.59924 1.60462 1.59691
Jan 05, 20 1.60581 1.60176 1.59448 1.59688
Jan 06, 20 1.61447 1.60167 1.6003 1.59689
Jan 07, 20 1.62315 1.59003 1.5878 1.59686
Jan 08, 20 1.61694 1.6063 1.5992 1.59689
Jan 09, 20 1.61973 1.59705 1.59838 1.59689
Jan 10, 20 1.61073 1.59329 1.58594 1.59685
Jan 13, 20 1.61190 1.60036 1.59643 1.59688
Jan 14, 20 1.61214 1.58956 1.59848 1.59689
Jan 15, 20 1.61471 1.5943 1.58943 1.59686
Jan 16, 20 1.61427 1.59522 1.59557 1.59688
Jan 17, 20 1.61326 1.59035 1.59977 1.59689
Jan 18, 20 1.61351 1.60866 1.59297 1.59687
Jan 19, 20 1.61351 1.60398 1.5955 1.59688 Fig. 7 Forecast exchange rates vs actual price of EUR/USD.
Jan 20, 20 1.61360 1.59844 1.6013 1.5969
Jan 21, 20 1.61930 1.59271 1.59235 1.59687
Jan 22, 20 1.62147 1.59448 1.59629 1.59688
Jan 23, 20 1.61537 1.59973 1.59021 1.59686 and Aloui [36], Alhagyan [4], Balabana and Lub [12], Kim
Jan 24, 20 1.61588 1.59078 1.59568 1.59688
et al. [28], and Han et al. [23] that argued long memory models
Jan 25, 20 1.61546 1.60175 1.60427 1.59691
are best suited in empirical analysis.
Jan 26, 20 1.61546 1.60001 1.5948 1.59688
Jan 27, 20 1.63050 1.5974 1.59174 1.59687 Furthermore, the findings show that SV model possess
Jan 28, 20 1.63052 1.59465 1.60206 1.5969 good characteristics which enable it to provide details of the
Jan 29, 20 1.63148 1.59629 1.59907 1.59689 empirical features of the joint time–series behavior of exchange
Jan 30, 20 1.64189 1.60354 1.6008 1.5969 rate. In addition, by merging FBM into SV model, real market
MSE 0.00045111 0.00048842 0.00044829 behaviors can be described more accurately since these models
have memory, or dependency.
Tables 4-6 and Fig. 7 indicate that the forecasted exchange
models under study and the computed values of MSE. While rates are closer together and less fluctuated than the actual
Table 7 summarizes the level of accuracy ranking for forecast- exchange rates. However, Model 3 is more stable than other
ing models according to the values of MSE. forecasted models since this model provides the smallest value
From the findings, Model 3 (GFBM perturbed by SV) of volatility. In general, the difference between the values of
demonstrates the most accurate in performance according to MSE of all forecasting models are small. Consequently, all
the smallest values of MSE at the three cases. This result comes models under study reveal high accuracy and can apply in fore-
because Model 3 includes two sources of memory H1 and H2 in casting exchange rates of EUR/SAR, EUR/USD and EUR/
addition to the assumption of stochastic volatility that obeys AUD 9 (see Figs. 8 and 9).
fractional Orenstein - Uhlenbeck process. While Model 1 has
no memory ðH ¼ 0:5Þ and Model 2 has only one source of long
memory ðH1 > 0:5Þ. Moreover, the volatility in both Model 1
and Model 2 is assumed to be constant.
By comparing between Model 1 and Model 2, one can
observe an alternating accuracy, which mean there is not clear
affection of incorporating only memory into GBM. While in
the case of Model 3 the affection is clear since Model 3 have
always highest accuracy. This proves the direct positive effect
of incorporating of both memory and stochastic volatility into
GBM.
These findings are consistent with previous studies such as
Painter [35], Willinger et al. [45], Grau–Carles [21], Rejichi

Table 7 MSEs of each model for each exchange rate.

Model 1 Model 2 Model 3
EUR/SAR 0.0026383 0.0025897 0.0024805
EUR/USD 0.0001407 0.0001438 0.0001346
EUR/AUD 0.0004511 0.0004884 0.0004483
Fig. 8 Forecast exchange rates vs actual price of EUR/SARR.
The effects of incorporating memory and stochastic volatility into GBM to forecast exchange rates of Euro
Fig. 9 Forecast exchange rates vs actual price of EUR/AUDR.
3. Conclusion
The exchange rates play a significant role in financial trading
for any country, especially in international trading. Therefore,
knowing the direction of exchange rates in future is one of the
priority of stakeholders. For this target, many scholars in liter-
ature proposed several models. One of the most important of
them is a Geometric Brownian motion GBM model. In litera-
ture, many theoretical and empirical studies discussed both
importance of memory and importance stochastic volatility
assumption upon financial environments. This empirical study
investigated the effect of merging memory and stochastic
volatility into the classical geometric Brownian motion model
by forecasting the exchange rate of Euro corresponding to
three currencies including USD, SAR and AUD.
The forecasting was conducted via three stages according to
three models of GBM. Stage one, traditional GBM without
considering memory nor stochastic volatility assumption using
Model 1. Stage 2, GFBM with considering memory and ignor-
ing stochastic volatility assumption using Model 2. Finally
stage 3, GFBM with considering memory and stochastic
volatility assumption using Model 3.
The results showed that Model 3 has the best performance
according to smallest value of MSE. This reflects the direct
positive affection of incorporating memory and stochastic
volatility assumption into GBM as an instrument of forecast-
ing the price of currencies exchange rate. These results consist
with many empirical studies such as Painter [35], Willinger
et al. [45], Grau–Carles [21], Rejichi and Aloui [36], Alhagyan
[4], Balabana and Lub [12], Kim et al. [28], and Han et al. [23].
Generally, the results exhibited that Model 3 exposed high
level of accuracy and thus it can apply in forecasting future
prices of exchange rates of for EUR/SAR, EUR/USD and
EUR/AUD.
Declaration of Competing Interest
The authors declare that they have no known competing
financial interests or personal relationships that could have
appeared to influence the work reported in this paper.
9607
Acknowledgment
This publication was supported by the Deanship of Scientific
Research at Prince Sattam bin Abdulaziz University, Al-
Kharj, Saudi Arabia.
References
[1] A. Abbas, M. Alhagyan, The effect of incorporating memory
and stochastic volatility into geometric brownian motion in
forecasting the performance of Tadawul All Share Index (TASI),
Adv. Appl. Statist. 74 (1) (2022) 47–62.
[2] R. Ahlip, M. Rutkowski, Pricing of foreign exchange options
under the MPT stochastic volatility model and the CIR interest
rates, Eur. J. Finance 22 (7) (2016) 551–571.
[3] Y. Aı̈t-Sahalia, A.W. Lo, Nonparametric estimation of state-
price densities implicit in financial asset prices, J. Finance 53 (2)
(1998) 499–547.
[4] M.K.M. Alhagyan, Modeling financial environments using
geometric fractional Brownian motion model with long
memory stochastic volatility (Doctoral dissertation, Universiti
Utara Malaysia), (2018).
[5] M. Alhagyan, F. Alduais, Forecasting the performance of
Tadawul all share index (TASI) using geometric Brownian
motion and geometric fractional Brownian motion, Adv. Appl.
Statist. 62 (1) (2020) 55–65.
[6] M. Alhagyan, M. Misiran, Z. Omar, Geometric fractional
brownian motion perturbed by fractional ornstein-uhlenbeck
process and application on KLCI option pricing, OALib 03 (08)
(2016) 1–12.
[7] M. Alhagyan, M. Misiran, Z. Omar, Estimation of geometric
fractional Brownian motion perturbed by stochastic volatility
model, Far East J. Math. Sci. 99 (2) (2016) 221.
[8] M. Alhagyan, M. Misiran, Z. Omar, Discussions on continuous
stochastic volatility models, Global Stochastic Anal. 7 (1) (2020)
55–64.
[9] M. Alhagyan, M. Misiran, Z. Omar, On effects of stochastic
volatility and long memory towards mortgage insurance models:
an empirical study, Adv. Appl. Statist. 66 (2) (2021) 165–174.
[10] M. Alhagyan, M. Misiran, Z. Omar, N.E.A. Hadi, N.
Phewchean, K. Matarneh, Value at risk with stochastic
volatility perturbed by hurst parameter, Adv. Appl. Statist. 70
(1) (2021) 31–43.
[11] G. Bakshi, C. Cao, Z. Chen, Pricing and hedging long-term
options, J. Economet. 94 (1-2) (2000) 277–318.
[12] E. Balabana, S. Lub, Color of noise: Comparative analysis of
sub-periodic variation in empirical Hurst exponent across
foreign currency changes and their pairwise differences, 2018.
Available at SSRN 3273656.
[13] A. Bardhan, R. Karapandža, B. Urošević, Valuing mortgage
insurance contracts in emerging market economies, J. Real
Estate Financ. Econ. 32 (1) (2006) 9–20.
[14] F. Biagini, Y. Hu, B. Øksendal, T. Zhang, Stochastic calculus
for fractional Brownian motion and applications, Springer
Science & Business Media, 2008.
[15] C.C. Chen, S.K. Lin, W.S. Chen, Mortgage insurance premiums
and business cycle, Tunghai University Working Paper, 2013.
[16] A. Chronopoulou, F.G. Viens, Stochastic volatility and option
pricing with long-memory in discrete and continuous time,
Quantit. Finance 12 (4) (2012) 635–649.
[17] F. Comte, E. Renault, Long memory in continuous-time
stochastic volatility models, Math. Finance 8 (4) (1998) 291–323.
[18] J. Gatheral, T. Jaisson, M. Rosenbaum, Volatility is rough,
Quant. Finance 18 (6) (2018) 933–949.
[19] X. Gong, X. Zhuang, Pricing foreign equity option under
stochastic volatility tempered stable Lévy processes, Physica A
483 (2017) 83–93.
9608
[20] G. Gözgör, The application of stochastic processes in exchange
rate forecasting: Benchmark test for the EUR/USD and the
USD/TRY, Econ. Comput. Econ. Cybernet. Stud. Res. 47 (2)
(2013) 225–246.
[21] P. Grau-Carles, Empirical evidence of long-range correlations in
stock returns, Physica A 287 (3-4) (2000) 396–404.
[22] P.S. Hagan, D. Kumar, A.S. Lesniewski, D.E. Woodward,
Managing smile risk, The Best of Wilmott 1 (2002) 249–296.
[23] C. Han, Y. Wang, Y. Xu, Nonlinearity and efficiency dynamics
of foreign exchange markets: evidence from multifractality and
volatility of major exchange rates, Econ. Res.-Ekonomska
Istraživanja 33 (1) (2020) 731–751.
[24] S.L. Heston, A closed-form solution for options with stochastic
volatility with applications to bond and currency options, Rev.
Financ. Stud. 6 (2) (1993) 327–343.
[25] J. Hull, A. White, The pricing of options on assets with
stochastic volatilities, J. Finance 42 (2) (1987) 281–300.
[26] M. Iseringhausen, The time-varying asymmetry of exchange rate
returns: A stochastic volatility–stochastic skewness model, J.
Empirical 58 (2020) 275–292.
[27] B. Kim, I.-S. Wee, Pricing of geometric Asian options under
Heston’s stochastic volatility model, Quantitative Finance 14
(10) (2014) 1795–1809.
[28] K.H. Kim, N.U. Kim, D.C. Ju, J.H. Ri, Efficient hedging
currency options in fractional Brownian motion model with
jumps, Physica A 539 (2020) 122868.
[29] A. Kukush, Y. Mishura, E. Valkeila, Statistical inference with
fractional Brownian motion, Stat. Infer. Stoch. Process. 8 (1)
(2005) 71–93.
[30] Y. Mishura, Stochastic calculus for fractional Brownian motion
and related processes, Springer, Berlin, 2008.
[31] Y. Mishura, A. Swishchuk, Modeling and pricing of variance
and volatility swaps for stochastic volatilities driven by
fractional Brownian motion, Appl. Statist. Actuarial Financ.
Math. 1–2 (2010) 52–67.
[32] M. Misiran, Modeling and pricing financial assets under long
memory processes, Doctoral dissertation, Curtin University,
2010.
M. Alhagyan
[33] M. Misiran, L. Zudi, K.L. Teo, A. Grace, Estimating dynamic
geometric fractional Brownian motion and its application to
long-memory option pricing, Dyn. Syst. Appl. 21 (1) (2012) 49–
66.
[34] A. Nicita, Exchange rates, international trade and trade policies,
Int. Econ. 135-136 (2013) 47–61.
[35] S. Painter, Numerical method for conditional simulation of
Levy random fields, Math. Geol. 30 (2) (1998) 163–179.
[36] I.Z. Rejichi, C. Aloui, Hurst exponent behavior and assessment
of the MENA stock markets efficiency, Res. Int. Business
Finance 26 (3) (2012) 353–370.
[37] S.M. Ross, An introduction to mathematical finance: options
and other topics, Cambridge University Press, 1999.
[38] L.O. Scott, Option pricing when the variance changes randomly:
Theory, estimation, and an application, J. Financ. Quantit.
Anal. 22 (4) (1987) 419–438.
[39] E.M. Stein, J.C. Stein, Stock price distributions with stochastic
volatility: an analytic approach, Rev. Financ. Stud. 4 (4) (1991)
727–752.
[40] Jeremy Stein, Overreactions in the options market, J. Finance 44
(4) (1989) 1011–1023.
[41] O. Vasicek, An equilibrium characterization of the term
structure, J. Financ. Econ. 5 (2) (1977) 177–188.
[42] X. Wang, W. Zhang, January). Parameter estimation for long-
memory stochastic volatility at discrete observation, Abstract
Appl. Anal. 2014 (2014) 1–10.
[43] X. Wang, D. Xie, J. Jiang, X. Wu, J. He, Value-at-Risk
estimation with stochastic interest rate models for option-bond
portfolios, Finance Res. Lett. 21 (2017) 10–20.
[44] U.F. Wiersema, Brownian motion calculus, John Wiley & Sons,
2008.
[45] W. Willinger, M.S. Taqqu, V. Teverovsky, Stock market
prices and long-range dependence, Finance Stochast. 3 (1)
(1999) 1–13.
[46] W. Xiao, W. Zhang, X. Zhang, Parameter identification for the
discretely observed geometric fractional Brownian motion, J.
Stat. Comput. Simul. 85 (2) (2015) 269–283.