Forecasting foreign exchange rates subject to de-volatilization

38 Pages·1992·0.79 MB·English

by  Zhou, Bin, 1956-

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Forecasting Foreign Exchange Rates
Subject to De-volatilization
by
Bin Zhou
MIT Sloan School Working Paper 3510
December 1992
MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
50 MEMORIAL DRIVE
CAMBRIDGE, MASSACHUSETTS 02139

Forecasting Foreign Exchange Rates
Subject to De-volatilization
by
Bin Zhou
MIT Sloan School Working Paper 3510
December 1992
M
jwn 1983
Forecasting Foreign Exchange Rates
Subject to De-volatilization
Bin Zhou
Sloan School of Management
Massachusetts Institute of Technology
MA
Cambridge, 02139
December, 1992
Abstract: There is a considerable literature analyzing behavior of ex-
change rates. However, modeling and forecasting exchange rates have not
been very successful. One of the obstacles to effective modeling of finan-
cial time series is heteroscedasticity. Recent availability of high frequency
data, such as tick-by-tick data, provides us extra information about the
market. Considering vast amount of data, this paper proposes to analyze
a homoscedastic subsequence of such data. The procedure of obtaining
such homoscedastic subsequence is called de-volatilization. Apparently, de-
volatilization can help us to detect trends of the market much fast. Our
forecasting results indicate that the exchange market is not efficient and can
be forecasted to certain extend.
Key Words: heteroscedasticity; high frequency data; volatility.
Introduction
1
Empirical studies have shown little success at forecasting foreign exchange
rates using structural and time series models (Meese and RogofF 1983a,b).
One of the obstacles to effective modeling and forecasting of exchange rates
is conditional heteroscedasticity (changing variance). The ARCH model ad-
dresses heteroscedasticity by estimating the conditional variance from histor-
ical data and has been used in modeling many financial time series. However,
forecasting exchange rates remains difficult. Recent availability of high fre-
quency data creates new possibilities for forecasting exchange rates.
High frequency data, such as minute-by-minute or tick-by-tick data, has
been brought to attention recently by Goodhart and Figliuoli (1991) and
Zhou (1992). As reported in Zhou's paper, high frequency data behaves
differently from low frequency data. It has a significant noise component.
Zhou suggested the following process for high frequency exchange rates:
S{t) = d{t) + B{T(t)) + e, (1)
where S{t) is logarithm of price at time t, B{-) is standard Brownian motion,
d{-) is a drift, r(-) is a positive increment function, tt is a mean zero random
noise, independent of Brownian motion B{-). Here r(<) is called cumulate
volatility and increment of r(6) — T{a) is called volatility in period [a, b]. The
return X{s,t) = S{t) — S(s) then has the following structure:
X{s,t) = ^lis.t) + a(s,t)Zt + ct - e, (2)
where Zt is a standard normal random variable and (T(s,t) = r(<) — t(s).
Returns of high frequency data are often negatively autocorrelated due to
the noises. This autocorrelation decreases as frequency decreases.
This paper presents a new approach to heteroscedasticity offinancial time
series. In Section 2, we introduce a de-volatilization procedure, one which
takes a homoscedastic subsequence from high frequency data. In Section 3,
we test the de-volatilization procedure by examining various properties of de-
volatilized exchange rates. Finally, in Section 4, we construct a forecasting
procedure from the de-volatilized time series.