Can Short Term Foreign Exchange Volatility Be Predicted by the Global

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EUROPEAN CENTRAL BANK

WORKING PAPER SERIES

ECB EZB EKT BCE EKP

WORKING PAPER NO. 66

CAN SHORT-TERM FOREIGN EXCHANGE VOLATILITY BE PREDICTED BY THE GLOBAL HAZARD INDEX?

BY VINCENT BROUSSEAU AND FABIO SCACCIAVILLANI

June 2001 WORKING PAPER SERIES

WORKING PAPER NO. 66

CAN SHORT-TERM FOREIGN EXCHANGE VOLATILITY BE PREDICTED BY THE GLOBAL HAZARD INDEX?

BY VINCENT BROUSSEAU AND FABIO SCACCIAVILLANI*

June 2001

* Authors’ e-mail address: [email protected]; [email protected] We wish to thank Satu Jaatinen for providing some of the data used in this study. Furthermore we acknowledge the extremely useful comments made by Charles Goodhart, Carsten Detken, Philipp Hartmann, Benoît Mojon, an anonymous referee and the participants at the Conference on “The euro: what’s in the future” in Venice on 8 to 9 June 2000. We accept sole responsibility for any remaining errors.The views expressed in this paper are not necessarily those of the European Central Bank. © European Central Bank, 2001 Address Kaiserstrasse 29 D-60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 D-60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d

All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank.

ISSN 1561-0810 Contents

Abstract 4

Executive summary 5

1 Introduction 7

2 A window on the influence of risk 9 2.1 Risk and Return 9 2.2 Volatilities as indicator of risk? 10 2.2.1 Historical volatilities 11 2.2.2 Implied volatilities 11

3 The Smoothing Kernel Method 12 3.1 First step: the conditional volatility of the bilateral exchange rate 12 3.1.1 Construction of the conditional volatility 13 3.1.2 A few words about the choice of the width parameter 14 3.2 Second step: weighted correlations and linear regressions 15 3.2.1 Recognising the pattern of the relationship 15 3.2.2 Filtering out unreliable observations 16 3.2.3 Measuring predictive powers 18

4 The empirical results 18 4.1 Data and main results 18 4.2 Discussion of the results 19 4.2.1 An overview on the major bilateral exchange rates 19 4.2.2 An overview on the exchange rates of selected small open developed economies 20 4.2.3 The overall results 22 4.3 How reliable are the results? 24

5 Conclusions 26

References 27

Charts 32

European Central Bank Working Paper Series 28

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Figure 18 - Topographic view of the probability that same results in regressions could be

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ECB • Working Paper No 66 • June 2001 47 /5 P ! Q!&I& B ;,,, /2 P' ! ! 6/Q!81 B8B ;,,, D, P& )81 !!Q!16" B ;,,, D- P48 ECB • Working Paper No 66 • June 2001 EH P% ! ! Q!)& ' ;,,- E@ P6# !Q!%& IA #= ' ;,,- E5 P1 !! + Q!= #Z ' ' ;,,- E2 P$ + !!Q!6) &% ' ;,,- H, P' # ! + Q! )' ( ! A6 ' ;,,- H- PI # Q!)' ( ! A6 ' ;,,- H; P% ! !Q!86 0 ' ;,,- H/ PI ! :Q!%B' 6!;,,- HD P) ! Q!A' &% !6!;,,- HE P'! B'A$Q!%& A6 6!;,,- HH P8 # ! ! :Q! X1 &% ( ;,,-

ECB • Working Paper No 66 • June 2001 49