Unconditional volatility main assumption is that volatility exhibits a constant variance

(homoskedasticity) and is estimated by ad hoc variable data transformations such as

rolling standard deviation, and coefficient of variation. Unlike the estimates of

unconditional moments, conditional volatility takes into account the fact that

exchange rate volatility may likely show up in clusters, periods of considerably high

amplitude followed by periods of low fluctuations. Thus, it assumes a time varying

variance. Conceptually this solves the unconditional volatility estimates’ problem

which is remaining apparently high when the underlying volatility is passing through

a tranquil phase and low over periods when the actual volatility is high. Conditional

volatility is estimated through an autoregressive conditional heteroskedasticity

(ARCH) model.

3.1.5 The Model

Considering exchange rate volatility, the export demand equation becomes: 7

𝛼 1
log(𝑥𝑡 ) = 𝑐 + log(𝐺𝐷𝑃𝑡∗ ) − log(𝑝𝑡 ) − 𝛾𝑉𝑂𝐿 + 𝜖𝑡 (3.24)
𝛽 𝛽

Equation 3.24 summarizes the factors affecting exports as suggested by

economic theory. Notice that exports are a function of the world demand, bilateral

country currency exchange rates, and a measure of exchange rate volatility.

According to economic literature, higher economic activity (GDPt) is expected to

have a positive effect on the amount of traded goods and services (exports) as people

tend to consume more during periods of economic expansion. Relative price changes

7
See Kenen and Rodrik (1986) work.

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