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A preliminary version of this paper was prepared during an external assignment at the Deutsche Bank between May and November 1999.1 am grateful to David Folkerts-Landau and Marcel Cassard for their support. The paper has benefited from suggestions by Jon Anderson, Troy Bowler, Susana Garcia-Cervero and Bart Turtelboom (Deutsche Bank); Peter Doyle, Elizabeth Milne, Marina Moretti and Abdourahmane Sarr (IMF) and participants in the Kiel Workshop on Integration of financial markets in Europe, particularly Michael Melvin and Christian Pierdzioch. Competent research assistance by Bahar Fadillioglu is acknowledged. The standard disclaimer applies.
Generalized Auto Regressive Conditional Heteroskedasticity models (GARCH models) are used to analyze high-frequency data showing volatility cluster patterns. The relative performance of currency option implied volatility and GARCH modeled volatility for both countries is shown in the Appendix.
Poland decided to float the Zloty in April 2000.
Implied volatility data is taken from quotes by Cantor Fitzgerald International for at the money currency options, as reported by Reuters.
The Burghardt-Lane methodology is designed to identify if options were cheap or dear, not if predictions were efficient or not, which is why it does not incorporate actual volatility separated from historical volatility.
In other words, it is more likely to show smaller deviations when predicting a variable that does not show large fluctuations.
One-year options are reported but not analyzed in light of reported distortions resulting from lack of liquidity in the market for options of this maturity.
For hard currencies, symmetry is the norm. However, for weak currencies, volatility should increase more acutely in the event of exchange rate depreciation as demand for a weak currency may eventually go down to zero.
Once the GARCH model is set up, an encompassing model would help measuring the relative performance of the market predictor (implied volatility) against the model predictor (GARCH conditional volatility). The results are shown in attached appendix.
It is not unusual to represent the mean equation as a pure random walk. In any case, to the extent that the expected value of the change in interest rate differentials and implied volatilities is zero, the mean equation do not have practical predictive power.
Volatility of the EURO was introduced explicitly as an independent variable, but it proved to be insignificant.
However, no formulation of central bank intervention appeared significant to explain conditional volatility.
Jochum, C and Kodres, L. (1997)