Wed, Mar 26 2008, 13:24 GMT
by Yapi Kredi Bank Economic Research Department
Once again, financial markets have experienced turmoil and subsequently the volatility in exchange rates soared. As we know from our past experiences, such disturbances hit the financial system from time to time and may lead to significant deterioration in the markets if the effect is permanent. These shocks might arise from different sources (e.g. internal and/or external), which make it difficult to differentiate between two. Exchange rates are sensitive to developments both in domestic and international markets and therefore are good indicators of uncertainty. Although the uncertainty itself cannot be directly observed, it is often approximated by volatility measures. The award wining (i.e. 2003 Nobel Prize) Autoregressive Conditional Heteroscedasticity (ARCH) methods are commonly used for this purpose.
Empirical findings suggest that volatility in currency markets are primarily driven by volatility in equity markets. However, credit default swap (CDS) market can be a better measure of credit risk as credit market developments might result in contrary movements across these markets. The volatility index (VIX) is the popular measure of implied volatility and is used to represent overall sentiment for equity options. As a result, there exists a significant correlation between VIX and the volatility in currency market.
The intent of this small exercise is to provide a brief but an appropriate framework to understand the underlying developments in daily nominal YTL/USD exchange rate between January 1, 2003 and March 19, 2008. Lira’s level and volatility movements are mostly inadequately interpreted if modeled at all. In this modest exercise, we attempt to accomplish exactly that. Due to its useful and powerful properties both in terms of financial and statistical aspects, the log returns (i.e. logarithmic first differences of exchange rates, cds and vix) will be used in modeling unless otherwise stated.
Published on Wed, Mar 26 2008, 13:27 GMT
Yapi Kredi
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