Amity University Kolkata

Assignment-1

INTERNATIONAL FINANCIAL MANAGEMENT

FIBA322

Submitted By:- Rahul Chakraborty

Semester-6B
Enrollment No. A90606421017

Under the Guidance of Dr. Rajib Dutta

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 Study of Exchange Rate Volatility Models:
Applications and Limitations

This comprehensive overview highlights the diverse applications and nuanced limitations of
various exchange rate volatility models, underscoring the importance of selecting appropriate
models based on specific analytical objectives and data characteristics.

1. ARCH and GARCH Models

Application: Autoregressive Conditional Heteroskedasticity (ARCH) and its generalized version

(GARCH) are widely used for modeling the volatility clustering phenomenon observed in financial
time series data, including exchange rates. These models capture the tendency for periods of high
volatility to cluster together.
Limitations: They assume that volatility is solely dependent on past squared observations and may
not fully capture all the complexities of exchange rate movements, such as sudden jumps or regime
shifts.

2. Stochastic Volatility Models

Application: Stochastic volatility models introduce time-varying volatility parameters, allowing
for more flexibility in capturing changes in volatility over time. They are particularly useful for
capturing sudden changes in volatility.
Limitations: Estimation of these models can be computationally intensive, and they may suffer
from identification issues, especially with short time series data.

3. Option-Implied Volatility Models

Application: Option-implied volatility models use market prices of options to infer market
expectations of future volatility. These models are valuable for extracting information about future
volatility directly from financial markets.
Limitations: They are subject to market frictions and may not always accurately reflect true
volatility expectations, especially during periods of market stress or illiquidity.

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 4. Realized Volatility Models
Application: Realized volatility models use high-frequency data to directly estimate volatility from
observed price changes. They provide a more accurate and timely measure of volatility compared
to traditional models.
Limitations: They require high-frequency data, which may not always be available or reliable for
all currencies or time periods.

5. Fractional Integration Models

Application: Fractional integration models capture the long memory properties often observed in
financial time series, including exchange rates. They are useful for modeling persistent volatility
patterns.
Limitations: They can be difficult to estimate and interpret, and they may not always provide
significant improvements over simpler models for short-term forecasting.

6. Limitations Across Models

All models are subject to the "forecasting horizon" problem, where their accuracy tends to diminish
as the forecast horizon increases.
They may assume that volatility follows a specific distribution (e.g., normal or Student's t-
distribution), which may not always hold true in practice.
Model parameters are often estimated using historical data, and their performance may deteriorate
during periods of structural change or regime shifts.

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 Conclusion
Exchange rate volatility models play a crucial role in understanding and managing risks associated
with currency movements. However, each model has its own set of strengths and weaknesses, and
no single model is universally superior. Researchers and practitioners often combine multiple
models or employ model averaging techniques to improve forecast accuracy and robustness.
Moreover, ongoing advancements in econometrics and computational techniques continue to drive
innovation in this field.

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