A utility-based comparison of some models of exchange rate volatility

When estimates of variances are used to make asset allocation decisions, underestimates of population variances lead to lower expected utility than equivalent overestimates: a utility-based criterion is asymmetric, unlike standard criteria such as mean squared error. To illustrate how to estimate a...

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Bibliographic Details
Published in:Journal of international economics 1993-08, Vol.35 (1), p.23-45
Main Authors: West, Kenneth D., Edison, Hali J., Cho, Dongchul
Format: Article
Language:English
Subjects:
Economic models
Exchange rates
Expected utility
Foreign exchange
Foreign exchange rates
Manycountries
Stochastic models
Studies
Volatility
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Summary:When estimates of variances are used to make asset allocation decisions, underestimates of population variances lead to lower expected utility than equivalent overestimates: a utility-based criterion is asymmetric, unlike standard criteria such as mean squared error. To illustrate how to estimate a utility-based criterion, we use five bilateral weekly dollar exchange rates, 1973–1989, and the corresponding pair of Eurodeposit rates. Of homoskedastic, GARCH, autoregressive and non-parametric models for the conditional variance of each exchange rate, GARCH models tend to produce the highest utility, on average. A mean squared error criterion also favors GARCH, but not as sharply.
ISSN:0022-1996
1873-0353
DOI:10.1016/0022-1996(93)90003-G