The IUP Journal of Applied Economics
The Interrelationship Between Implied and Realized Exchange Rate Volatility in India

Article Details
Pub. Date : Oct, 2018
Product Name : The IUP Journal of Applied Economics
Product Type : Article
Product Code : IJAE11810
Author Name : Sudarsana Sahoo and Pushpa Trivedi
Availability : YES
Subject/Domain : Economics
Download Format : PDF Format
No. of Pages : 20

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Abstract

This paper examines the relationship between the USD/INR implied volatility and future realized volatility by using non-overlapping monthly volatility data from April 2005 to March 2017. The empirical results suggest that the USD/INR implied volatility is biased, yet a better predictor of future realized volatility of the exchange rate than historical volatility and GARCH forecast. The out-of-sample forecast also shows that implied volatility outperforms both historical volatility and GARCH forecast in predicting future realized volatility. The implied volatility is found to be an efficient predictor vis-à-vis historical volatility as it subsumes all the information content of the historical volatility about future realized volatility. However, the GARCH forecast contains some incremental information about future realized volatility beyond the information contained in the implied volatility, though the predictive power of implied volatility remains higher than the GARCH forecast.


Description

Volatility of financial variables, viz., exchange rates, interest rates, stock prices, etc., is one of the major determinants of pricing of risky financial assets. Much emphasis has been given in the theoretical and empirical finance literature on forecasting of volatility of the financial variables including exchange rates. A reliable prediction of exchange rate volatility is critical for various economic agents with their future cash flows denominated in foreign currency, viz., exporters, importers, foreign currency borrowers and lenders, foreign investors, etc. The exchange rate volatility forecast is one of the most important factors for the foreign portfolio investors for deciding on their level of exposures to various currencies. The government and central banks, especially those in emerging market economies, are vigilant on the market expectation about volatility of their currencies and undertake market interventions to curb heightened expectations.

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