Exchange Rate Volatility Estimation

Using GARCH Models,

with Special Reference to Indian Rupee
Against World Currencies
Krishna Murari*
This study is an attempt to estimate the dynamics (volatility) of Indian rupee instability against four major world
currencies, i.e., US dollar, pound sterling, euro and Japanese yen, using 3,340 daily observations over a period of 13
years from January 3, 2000 to September 30, 2013. This paper uses the Generalized Autoregressive Conditional
Heteroskedastic (GARCH) models to estimate volatility (conditional variance) in the daily log rupee value. The
models include both symmetric and asymmetric that capture the most common stylized facts about rupee exchange
returns such as volatility clustering and leverage effect. It is evident from the findings that asymmetric models are
superior to symmetric models in providing a better fit for the exchange rate volatility because of leverage effect.

Introduction
The currency exchange rates volatility is among the most examined and analyzed economic
measures by the government. Recently, India had a big concern about rupee value with respect
to US dollar due to its all-time lowest (depreciated) value. On August 28, 2013, the Indian
rupee touched up to 68.825 against the dollar. It is not only the rupee depreciation but also
rupee appreciation that is causing concern to the economic imbalance of the country. Ahmed
and Suliman (2011) pointed out the importance of currency exchange rate volatility because
of its economic and financial applications like portfolio optimization, risk management, etc.
It is a well-known fact that the exchange rate volatility is not observed directly. A number of
models have been developed to get the accurate estimate of the volatility. Out of these,
conditional heteroskedastic1 models are frequently used. The foundation for building these
models is to make a good forecast of future volatility which would be helpful in obtaining a
more efficient portfolio distribution, better foreign exchange exposure management and
more accurate currency derivative prices.
Surrounded by these models, the Autoregressive Conditional Heteroskedasticity (ARCH)
model proposed by Engle (1982) and its extension, Generalized Autoregressive Conditional
Heteroskedasticity (GARCH) model by Bollerslev (1986) and Taylor (1986) are the first
*
1

Assistant Professor, Department of Management, School of Professional Studies, Sikkim University, 6th Mile,
Samdur, PO-Tadong, Gangtok, Sikkim 737102, India. E-mail: krishnamurari9@gmail.com
A financial time series is said to be heteroskedastic if its variance changes over time, otherwise it is called
homoskedastic.

2015 IUP. All Rights Reserved.

22

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

models that have become popular in enabling the analysts to estimate the variance of a series
at a particular point in time (Enders, 2004). Since then, there have been a great number of
empirical applications of modeling the conditional variance of a financial time series (Diebold
and Nerlolve, 1989; Nelson, 1991; Bollerslev et al., 1992; West and Cho, 1995; Engle and
Patton, 2001; Evans and Lyons, 2002; Shin, 2005; Charles et al., 2008; Jakaria and Abdalla,
2012; and Rossi, 2013). The focus of these studies was to design explicit models to forecast
the time-varying volatility of the series using past observations. The findings have been
applied successfully in the financial market research.
Many empirical studies have been done on modeling the exchange rate volatility by
applying GARCH specifications and their large extensions, but most of these studies have
focused on developed currencies, and to the best of our knowledge, there are no such practical
studies for estimating the volatility of Indian rupee against US dollar, pound sterling, euro
and Japanese yen (world major currencies); therefore, the current paper attempts to fill this
gap. The main objective of this paper is to model exchange rate return volatility for Indian
Rupee (INR) by applying different univariate specifications of GARCH type models for daily
observations of the rupee log differenced exchange rate return series. The volatility models
applied in this paper include the GARCH(p, q), Exponential GARCH(p, q), Threshold
GARCH(p, q), and Power GARCH(p, q).

Data and Methodology

The time series data for rupee exchange rate against most monitored world currencies is used
for modeling volatility. The daily rupee exchange rate against US dollar, pound sterling, euro
and Japanese yen for the period January 3, 2000 to September 30, 2013 is used to estimate the
volatility, resulting in total observations of 3,339, excluding public holidays. These data
series have been obtained from one of the most reliable sources in India, i.e., RBI online
database. In this study, daily returns are the first difference in logarithm of closing prices of
rupee exchange rate of successive days.

Volatility
It is helpful to give a brief explanation of the term volatility before starting the description of
volatility models. Statistically, volatility is frequently measured by the standard deviation
which reflects the degree of fluctuations of the observed values from the mean. Generally,
volatility means the stretch of all possible outcomes of a variable. Sometimes, variance is also
used as a volatility measure. In foreign exchange markets, we use the term volatility to reflect
the spread of currency returns over a time period. In this paper, we use the variance as a
measure of volatility.

Stylized Facts About Volatility of Exchange Rates

Mostly, financial time series, including exchange rate returns, are well known to show signs
of certain stylized patterns which are essential for proper model specification, estimation and
Exchange Rate Volatility Estimation Using GARCH Models,
with Special Reference to Indian Rupee Against World Currencies

23

forecasting. Mandelbrot (1963) and Fama (1965) were pioneers in documenting the empirical
regularities regarding these series. Since then many researchers have found similar regularities
about the financial time series (Baxter, 1991; Guillaume et al., 1997; and Cont, 2001). Due to
a large body of empirical evidence, these regularities can be considered as stylized facts. The
most common stylized facts are the following:

Heavy Tails
When the distribution of foreign exchange return time series is compared with normal
distribution, heavy tails are observed in terms of excess kurtosis. The standardized fourth
moment for a normal distribution is 3, whereas for many financial time series, a value well
above 3 is observed (Cont, 2001). A similar observation is witnessed in the present study also
(see Table 1).

Log
Difference
of RD (LRD)

Log
Difference
of RJY (LRJ)

Log
Difference
of RPS (LRPS)

77.66

45.96

57.38

46.84

0.01

0.01

0.02

0.01

Median

77.84

41.43

57.42

46.17

0.02

0.02

Maximum

106.03

72.12

91.47

68.36

3.68

5.76

4.15

4.02

Minimum

63.96

32.69

38.79

39.27

5.7

5.12

3.89

3.01

SD

6.89

9.70

9.76

4.19

0.64

0.83

0.69

0.44

Skewness

0.28

1.01

0.03

1.31

0.43

0.20

0.04

0.28

Kurtosis

2.92

2.90

2.65

6.02

7.85

6.89

5.16

10.94

45.62

564.75

17.8

2,221.66

3,376.36

2,125.5

652.03

8,822.54

Prob.

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Obs.

3,340

3,340

3,340

3,340

3,339

3,339

3,339

3,339

JB

Log
Difference
of RE (LRE)

INR per
Euro (RE)

Mean

INR per US
Dollar (RD)

INR per 100

Japanese
Yen (RJY)

INR per
Pound
Sterling (RPS)

Table 1: Descriptive Statistics

Volatility Clustering
Similar values/changes in the long run tend to accumulate and this is termed as volatility
clustering. In most of the time series, large and small values in the log-returns have a tendency
to occur in clusters. When volatility is high, it is likely to remain high, and when it is low, it
is likely to remain low. According to Engel and West (2005), volatility clustering is nothing
but accumulation or clustering of information. Volatility clustering is well evident in Figures
1 to 4.

Leverage Effects
The leverage effect refers to the negative correlation between an asset return and its volatility,
i.e., rising asset prices are accompanied by declining volatility and vice versa (Nelson, 1991;
Gallant et al., 1992; Campbell and Kyle, 1993; and Longmore and Robinson, 2004). In foreign
24

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

Figure 1: INR per US Dollar (RD) and Log Difference of RD (LRD)

6
4

LRD

2
0
2

70

60
RD

50
40
30

02

04

06

08

10

12

Figure 2: INR Against Euro (RE) and Log Difference of RE (LRE)

6
4

LRE

2
0
100

80

4
RE

60
40
20

02

04

06

Exchange Rate Volatility Estimation Using GARCH Models,

with Special Reference to Indian Rupee Against World Currencies

08

10

12

25

Figure 3: INR per 100 Japanese Yen (RJ) and Log Difference of RJ (LRJ)

6
LRJ

4
2
0

80

70

4
6

60

RJ

50
40
30

02

04

06

08

10

12

Figure 4: INR per Pound Sterling (RPS) and Log Difference of RPS (LRPS)

LRPS

2
0
110
2
100

RPS

90

80
70
60

26

02

04

06

08

10

12

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

exchange markets, it is repeatedly witnessed that currency depreciation is followed by higher

volatility.

Co-Movements in Volatility
Financial time series across different markets exhibit parallel fluctuations in terms of direction
of movements; for example, an upward movement in stock returns in Bombay Stock Exchange
(BSE) being matched by an upward movement in National Stock Exchange (NSE). These comovements in rupee exchange rate volatility are also observed in Figures 1 to 4.

Calendar Effects
Generally, the volatility of asset returns or exchange rate returns are lower during weekends
and holidays compared to normal trading days. The most common calendar anomalies that
affect the exchange rate volatility are the January effect and the day-of-the-week effect.
Many studies attribute this phenomenon to the accumulative effects of information during
weekends and holidays (Miller, 1984; Theobald and Price, 1984; Abraham and Ikenberry,
1994; Kaur, 2004; and Cai et al., 2006).

Volatility Estimation Models

Based on the literature reviewed, the volatility models can be divided into two main groups:
symmetric and asymmetric. The symmetric models reflect that the conditional variance
depends on the magnitude only, while the shocks of the same magnitude, positive or negative,
have different effect on future volatility in the class of asymmetric models.

Symmetric GARCH Model

ARCH models are specifically designed to model and forecast conditional variances. Under
GARCH modeling, the variance of the dependent variable is modeled as a function of past
values of the dependent variable.
The GARCH(p, q) Model: Higher order GARCH models, denoted by GARCH(p, q), can
be estimated by choosing either p or q greater than 1, where p is the order of the autoregressive
GARCH terms and q is the order of the moving average ARCH terms. The representation of
the GARCH(p, q) variance is:

t2

p
i 1

i 2t i

q
j 1

j t2 j

...(1)

We begin with the simplest GARCH (1, 1) specification:

Yt X t t

...(2)

t2 t21 t21

...(3)

where

= Constant term;
Exchange Rate Volatility Estimation Using GARCH Models,
with Special Reference to Indian Rupee Against World Currencies

27

2t 1 (the ARCH term) = news about volatility from the previous period, measured as the
lag of the squared residual from the mean equation; and

t21 (the GARCH term)= last periods forecast variance.

Asymmetric GARCH Models

The responsiveness of the conditional variance to rises and falls in asset return is an important
phenomenon in volatility estimation and the symmetric GARCH models fail in this regard.
Further, the symmetric GARCH model discussed above cannot provide explanation to the
leverage effects experienced in the exchange rate returns, therefore, a number of models have
been introduced to deal with this observable fact. These models are called asymmetric models.
In this paper, we use TGARCH, EGARCH and PGARCH models for tracing the asymmetric
phenomena.
The Threshold GARCH (TGARCH) Model: The generalized specification for the
conditional variance under TGARCH (Glosten et al., 1993; and Zakoian, 1994) is given by:

t2

p
i 1

i 2t i

q
j 1

j t2 j

k 1 k

2t k I t k

...(4)

where It = 1 if t < 0 and 0 otherwise.

In this model, good news, ti > 0, and bad news, ti < 0, have differential effects on the
conditional variance; good news has an impact of i, while bad news has an impact of i +i.
If i > 0, it means increased volatility due to bad news, and it is believed that there is a
leverage effect for the ith order. If i 0, there is asymmetric effect.
The Exponential GARCH (EGARCH) Model: The EGARCH model was proposed by
Nelson (1991). In this model, the asymmetric responses of variance to shocks are captured
and at the same time the positivity of variance is also ensured. The specification for the
conditional variance is:
log( t2 )

p
i 1

t i

ti

q
j 1

j log( t2 j )

k 1 k

t k
tk

...(5)

Here it should be noted that the left-hand side takes the log of the conditional variance
over time which implies the exponential nature of the leverage effect. Further, the estimates
for the conditional variance are positive. The existence of leverage effects can be checked by
the hypothesis that i < 0. The impact is asymmetric if i 0. The sign of is anticipated to be
positive in most practical cases.
The Power GARCH (PGARCH) Model: Taylor (1986) and Schwert (1989) introduced
another class of asymmetric GARCH models, where instead of modeling for variance, the
standard deviation is modeled and is called the standard deviation GARCH model. The
power constraint of the standard deviation can be projected and the optional parameters
are added to capture irregularity of up to order r:
28

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

q
j 1

j t j

p
i 1

i (|t i| i t i )

...(6)

where > 0, for | i | 1 for i = 1, , r, for all i > r, and r p .

The symmetric model puts i = 0 for all i. Here it is worth noting that if = 2 and i = 0
for all i, the PGARCH model is simply a standard GARCH specification. As in the prior
models, the asymmetric effects are present if 0.

Results and Discussion

The descriptive statistics of the rupee value and its first log difference against pound sterling
(RPS, LRPS), 100 Japanese yen (RJY, LRJ), euro (RE, LRE) and US dollar (RD, LRD) are
depicted in Table 1. During the study period, the rupee value was minimum, i.e., 63.96, 32.69,
38.79 and 39.27, against Pound Sterling (PS), Japanese Yen (JY), Euro (E) and US Dollar (D),
respectively, whereas the rupee value was maximum against PS, i.e., 106.03. The mean of
rupee exchange return series varied to a greater extent against euro with standard deviation
of 9.76. The skewness for the log difference of exchange return series, i.e., LRPS, LRJ, LRE and
LRD are 0.43, 0.2, 0.04 and 0.28, respectively. In a standard normal distribution, skewness
is zero. A positive and negative value of skewness in the log return series shows asymmetry.
So, in our result, LRPS and LRE show a negatively skewed distribution and LRJ and LRD
show a positively skewed distribution, i.e., asymmetric data series. In a standard normal
distribution, kurtosis is 3. A value lesser or greater than 3 kurtosis coefficients indicates
flatness and peakedness of the data series. The kurtosis of all the series is different from the
standard value, except for RPS (2.92) and RJY (2.9) which is very close to 3. The higher value
of kurtosis for LRPS, LRJ, LRE and LRD shows that the data series is peaked, moreover LRD
data series is highly peaked with kurtosis 10.94 as compared to normal distribution. Table 1
also shows that the Jarque-Bera (JB) test of normality for all the data series rejects the null
hypothesis of normality at 1% significant level.
The visual inspection of the rupee value and log difference against the selected currencies
is depicted in Figures 1 to 4. From the figures, it is clearly visible that the high volatility or
frequent changes in LRPS, LRJ, LRE and LRD data series show the clustering.

Testing for Stationarity of the Series

To investigate whether the daily rupee value against PS, E, D and JY and their first log
difference are stationary series, the Augmented Dickey-Fuller (ADF) test (Dickey and Fuller,
1979), Philips-Perron (PP) test (Phillips and Perron, 1988) and Kwiatkowski-PhillipsSchmidt-Shin (KPSS) test (KPSS, 1992) have been applied to confirm the results about the
stationarity of the series. The results of the unit root test are shown in Table 2. The ADF and
PP test statistics for LRD, LRPS, LRE and LRJ are significant at 1% level, thus rejecting the
null hypothesis of the presence of unit root in the data. Similar results are obtained with
KPSS test under the null hypothesis of absence of unit root in the series. ADF and PP tests
with null hypothesis of unit root and KPSS test with null hypothesis of no unit root in the
series confirm that LRD, LRPS, LRE and LRJ are stationary at levels itself.
Exchange Rate Volatility Estimation Using GARCH Models,
with Special Reference to Indian Rupee Against World Currencies

29

Table 2: Unit Root Test

Series

ADF Test
t-Statistics

p-Value

PP test
Adj.
t-Statistics

(Null: Unit Root)

p-Value

(Null: Unit Root)

KPSS
Test
Statistics

p-Value

(Null: No Unit Root)

LRD

42.62

0.00

57.01

0.00

1.43

0.15

LRPS

42.82

0.00

56.94

0.00

0.98

0.33

LRE

58.76

0.00

58.76

0.00

1.64

0.10

LRJ

59.85

0.00

59.93

0.00

0.85

0.40

Testing for Heteroskedasticity

We cannot use homoskedastic model to estimate volatility. Thus, before modeling the
volatility of rupee exchange log return series against major currencies, testing for the
heteroskedasticity in residuals is necessary. At the beginning, we obtain the residuals from an
Autoregressive and Moving Average (ARMA) process as specified by Equation (7). This
model represents that the present value of a time series depends upon its past values, which
is the autoregressive component, and on the preceding residual values, which is the moving
average component (Murari, 2013). The ARMA(p, q) model can be presented in the following
general form:
Yt 1 Yt 1 0 t 1 t 1

...(7)

where
Yt is the dependent variable at time t;

is the constant term;

0 and 1 are residual coefficients;
Yt1 is the lagged dependent variable;

1 is the regression coefficient;

t is the residual term; and
t1 is the previous values of the residual.

ARCH-LM Test
Once the residuals from ARMA(1, 1) are obtained, the existence of heteroskedasticity in
residuals of log exchange rate return series is checked using Engles Lagrange Multiplier (LM)
test for ARCH effects (Engle, 1982). This particular heteroskedasticity specification was
motivated by the observation that in many financial time series, the magnitude of residuals
appeared to be related to the magnitude of recent residuals (Chakrabarti and Sen, 2011).
However, ignoring ARCH effects may result in loss of efficiency.
The ARCH LM test-statistic is calculated from a supporting test regression. To test the null
hypothesis that there is no ARCH up to order q in the residuals, we use the following regression:
30

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

2t 0

q
s 1

0 2t s vt

...(8)

where is the residual.

In the above equation, the squared residuals are regressed on lagged squared residuals up
to order q. We use two (F-statistics and Engles LM test statistic) test statistics from this test
regression.
Table 3 presents the results of heteroskedasticity test LM to check for the presence of
ARCH effect in the residual series of LRD, LRPS, LRE and LRJ at lag 1. From the table, we
infer that for all the log rupee exchange return series, both F-statistics and LM statistics are
significant at 1% level in the first lags. The zero p-value indicates the presence of ARCH
effect. Based on these results, we reject the null hypothesis of absence of ARCH effects
(homoskedasticity) in residual series of log rupee exchange return series. These results suggest
that the log return series of Indian rupee-against US dollar, pound sterling, euro and Japanese
yen have the presence of ARCH. This observation directs us to estimate the exchange rate
volatility using different classes of GARCH models.
Table 3: ARCH-LM Test Results
Series

ARCH
F-Statistics

Prob.
F(1,3336)

LM-Statistics

Prob.
2 (1)

LRD

227.74

0.00

213.31

0.00

LRPS

49.19

0.00

48.50

0.00

LRE

64.87

0.00

63.67

0.00

LRJ

325.87

0.00

297.05

0.00

Symmetric Model: GARCH(p, q)

Table 4 shows the results of GARCH(p, q) model used for estimating the daily foreign exchange
rate volatility of Indian rupee against four major currencies of the world for the sample period
ranging from January 3, 2000 to September 30, 2013.
From the table we can see that all the coefficients of rupee against different currencies,
(Constant), (ARCH effect) and (GARCH effect), in the sample period are statistically
significant at 1% level. GARCH(1, 1) model for series LRD and LRJ showed the presence of
further ARCH in residuals. Thus, we estimated GARCH(2, 1) model for LRD and LRJ which
shows the significant ARCH-LM test statistics (Table 4). The lagged conditional and squared
variances have impact on the volatility and it is supported by both ARCH Term () and
GARCH Term () which is significant.
The highly significant (ARCH effect) in the sample period evidenced the presence of
volatility clustering in GARCH(1, 1) model in LRPS and LRE series. It also indicates that
the past squared residual term (ARCH term) is significantly affected by the volatility risk in
Indian rupee against pound sterling and euro. The coefficient of (GARCH effect) also
Exchange Rate Volatility Estimation Using GARCH Models,
with Special Reference to Indian Rupee Against World Currencies

31

Table 4: Estimation Results of GARCH(p, q) Model

LRD

LRPS

LRE

LRJ

GARCH
(1, 1)

GARCH
(2, 1)

GARCH
(1, 1)

GARCH
(1, 1)

GARCH
(1, 1)

GARCH
(2, 1)

Constant ()

0.000342

0.00015

0.00505

0.00400

0.019517

0.01295

ARCH Effect (1)

0.273045*

0.39708*

0.05143*

0.04942*

0.100899*

0.17630*

ARCH Effect (2)

0.23775*

0.10819*

GARCH Effect () 0.7846*

0.87002*

0.93588*

0.94305*

0.871744*

0.91288*

i +j

1.02935

0.98731

0.99247

0.972643

1.08918

1.057645

Residual Diagnostics: ARCH-LM Test

F-Statistic
Prob. F(1,3336)

12.35045
0.0004

0.603694

0.602994

0.00669

0.4372

0.4375

0.9348

17.3168
0

2.598767
0.107

Note: * indicates that the coefficients are significant at 1% level.

shows highly statistical significance for rupee exchange rate against major world currencies.
It indicates that the past volatility of Indian foreign exchange rate is significantly influencing
the current rupee volatility.
The sum of coefficients of ARCH term and GARCH term and (persistent coefficients)
in GARCH(p, q) model reported in Table 4 are near to one for all the series, suggesting that
shocks to the conditional variance are highly persistent, i.e., the conditional variance process
is volatile. This shows that the volatility clustering phenomenon is implied in exchange rate
return series.

Asymmetric GARCH Models

Threshold GARCH/TGARCH(p, q)
The TGARCH model used to test leverage effect or asymmetry in the daily foreign exchange
rate volatility of Indian rupee against US dollar, pound sterling, euro and Japanese yen is
shown in Table 5. The estimated results of coefficients in TGARCH(p, q) model for the series
LRD, LRPS, LRE and LRJ are statistically significant at 1% and 5% levels of significance.
In the case of asymmetric term or leverage effect (), a statistically significant value suggests
that there exists the leverage effect and asymmetric behavior in daily Indian rupee exchange
rate against US dollar, pound sterling, euro and Japanese yen. Further for all the series, the
leverage effect term shows a negative sign, indicating that positive shocks (good news) have
large effect on next period volatility than negative shocks (bad news) of the same sign or
magnitude. TGARCH(1, 1) modeling for LRD and LRJ shows the presence of further ARCH
in the residuals, thus we use TGARCH (2, 1) model in order to achieve better results. The
ARCH-LM test statistics for LRD and LRJ at TGARCH(2, 1) and for LRPS and LRJ at
TGARCH(1, 1) did not exhibit additional ARCH effect. This shows that the variance
equations are well precise.
32

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

Table 5: Estimation Results of TGARCH(p, q) Model

LRD

LRPS

LRE

LRJ

TGARCH TGARCH TGARCH TGARCH TGARCH TGARCH

(1, 1)
(2, 1)
(1, 1)
(1, 1)
(1, 1)
(2, 1)
Constant ()

0.000342

0.000147

0.004964

0.004177

0.021446

0.014193

ARCH Effect (1)

0.306522*

0.39711*

0.05690*

0.06106*

0.120594*

0.18210*

ARCH Effect (2)

0.00301**

Leverage Effect () 0.06619*

0.23511* 0.01110*

0.02535**
0.02503* 0.04014*

0.10183*

GARCH Effect ()

0.783613*

0.86903*

0.93635*

0.943543* 0.867794*

0.910441*

i +j

1.090135

1.26614

0.99325

1.00460

1.09254

0.988388

Residual Diagnostics: ARCH-LM Test

F-Statistic

11.66325

Prob. F(1,3336)

0.0006

0.633212

0.652476

0.013669

0.4262

0.4193

0.9069

22.14605

3.376216

0.0662

Note: * and ** indicate that the coefficients are significant at 1% and 5% levels, respectively.

Exponential GARCH/EGARCH(p, q) Model

Table 6 presents the estimated results of EGARCH(p, q) model to test the asymmetric behavior
of Indian foreign exchange rate against major world currencies.
Table 6: Estimation Results of EGARCH(p, q) Model
LRD

LRPS

LRE

LRJ

EGARCH EGARCH EGARCH EGARCH EGARCH EGARCH

(1, 1)
(2, 1)
(1, 1)
(1, 1)
(1, 1)
(2, 1)
Constant ()
ARCH Effect (1)

0.3515
0.440692*

ARCH Effect (2)

0.26373
0.57298*

0.10255
0.11638*

0.09471
0.10868*

0.12811
0.158255*

0.23452**

0.10544
0.30817*
0.17716**

Leverage Effect ()

0.03715*

0.027829* 0.009054*

0.021398*

0.014956*

0.017479*

GARCH Effect ()

0.987516*

0.993237* 0.98770*

0.98836*

0.986088*

0.990482*

i +j

1.428208

1.56622

1.09704

1.144343

1.29865

1.10408

Residual Diagnostics: ARCH-LM Test

F-Statistic
Prob. F(1,3336)

26.94159
0

1.483617

0.239194

0.023062 110.6067

1.706964

0.2233

0.6248

0.8793

0.1915

Note: * and ** indicate that the coefficients are significant at 1% and 5% levels, respectively.

All the parameters presented in the table are statistically significant at 1% and 5% levels.
The significance of EGARCH term () indicates the presence of asymmetric behavior of
volatility of Indian rupee against US dollar, pound sterling, euro and Japanese yen. The positive
coefficients of EGARCH term suggest that the positive shocks (good news) have more effect
on volatility than that of negative shocks. The null hypothesis of no heteroskedasticity in
Exchange Rate Volatility Estimation Using GARCH Models,
with Special Reference to Indian Rupee Against World Currencies

33

the residuals is accepted for LRPS and LRE, but not for LRD and LRJ in EGARCH(1, 1)
model.

Power GARCH/PGARCH(p, q) Model

The results of modeling the standard deviation (PGARCH) rather than modeling of variance
as in most of the GARCH family models are presented in Table 7.
Table 7: Estimation Results Using PGARCH(p, q)
LRD

LRPS

LRE

LRJ

PGARCH PGARCH PGARCH PGARCH PGARCH PGARCH

(1, 1)
(2, 1)
(1, 1)
(1, 1)
(1, 1)
(2, 1)
Constant

0.000342

ARCH Effect (1)

0.272314*

0.000141

0.002933

0.395929* 0.030942*

0.005614

0.025614

0.055991*

0.114605*

ARCH Effect (2)

0.00175*

Leverage Effect () 0.06084*

0.23595* 0.04739** 0.15821*

0.016315
0.173314*
0.04097**

0.09243*

0.09735*

GARCH Effect ()

0.783649*

0.869056* 0.935482*

0.944103*

0.870101*

0.913422*

Power Parameter

2.000885*

2.013997* 3.030564*

1.400777*

1.457562*

1.498009*

i +j

1.055963

1.264985

1.000094

0.984706

1.086736

0.966424

Residual Diagnostics: ARCH LM Test

F-Statistic
Prob. F(1,3336)

11.66511
0.0006

0.605952

0.463149

0.003725

0.4364

0.4962

0.9513

41.81468
0

9.529872
0.002

Note: * and ** indicate that the coefficients are significant at 1% and 5% levels, respectively.

It is evident from Table 7 that the estimated coefficients are significant and negative for
all the exchange rate return series in PGARCH(1, 1) model, indicating that negative shocks
are associated with higher volatility than positive shocks. The ARCH-LM test statistics did
not exhibit additional ARCH effect for LRPS and LRE under PGARCH(1, 1) model, but
LRD and LRJ witnessed the presence of further ARCH in the residuals of the model.
Thus, PGARCH (2, 1) model is estimated to eliminate the presence of ARCH effect where
null hypothesis of no ARCH is accepted. This shows that the variance equations are well
specified.

Conclusion
Exchange rate volatility estimation is considered as an important concept in many economic
and financial applications like currency rate risk management, asset pricing, and portfolio
allocation. This paper attempts to explore the comparative ability of different statistical and
econometric volatility forecasting models in the context of Indian rupee against US dollar,
pound sterling, euro and Japanese yen. Four different models were considered in this study.
The volatility of the rupee exchange rate returns has been modeled by using univariate
GARCH models. The study includes both symmetric and asymmetric models that capture
the most common stylized facts about currency returns such as volatility clustering and
34

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

leverage effect. These models are GARCH(1, 1), EGARCH(1, 1), TGARCH(1, 1) and
PGARCH(1, 1) for log difference of rupee exchange rate return series against pound sterling
and euro and GARCH(2, 1), EGARCH(2, 1), TGARCH(2, 1) and PGARCH(2, 1) for log
difference of rupee exchange rate return series against US dollar and Japanese yen.
GARCH(1, 1) and GARCH(2, 1) models are used for capturing the symmetric effect, whereas
the other group of models for capturing the asymmetric effect. The paper finds strong evidence
that daily rupee exchange returns volatility could be characterized by the above-mentioned
models. For all series, the empirical analysis was supportive of the symmetric volatility
hypothesis, which means rupee exchange rate returns are volatile and that positive and
negative shocks (good and bad news) of the same magnitude have the same impact and effect
on the future volatility level. The parameter estimates of the GARCH(p, q) models indicate
a high degree of persistence in the conditional volatility of exchange rate returns of rupee
against world major currencies which means an explosive volatility.

References
1. Abraham A and Ikenberry D (1994), The Individual Investor and the Weekend Effect,
Journal of Financial and Quantitative Analysis , Vol. 29, No. 752, pp. 263-277.
2. Ahmed E M and Suliman Z (2011), Modeling Stock Market Volatility Using GARCH
Models: Evidence From Sudan, International Journal of Business and Social Science , Vol. 2,
No. 23, pp. 114-128.
3. Baxter M (1991), Business Cycles, Stylized Facts and the Exchange Rate Regime:
Evidence from the United States, Journal of International Money and Finance, Vol. 10,
No. 1, pp. 71-88.
4. Bollerslev T (1986), Generalized Autoregressive Conditional Heteroscedasticity,
Journal of Econometrics, Vol. 31, No. 3, pp. 307-327.
5. Bollerslev T, Chou R and Kroner F (1992), ARCH Modeling in Finance: A Review of
the Theory and Empirical Evidence, Journal of Econometrics, Vol. 52, Nos. 1 & 2,
pp. 5-59.
6. Cai J, Li Y and Qi Y (2006), The Day-of-the-Week Effect: New Evidence from the
Chinese Stock Market, The Chinese Economy, Vol. 39, No. 2, pp. 71-88.
7. Campbell J and Kyle A (1993), Smart Money, Noise Trading and Stock Price Behaviour,
Review of Economic Studies, Vol. 1, No. 1, pp. 1-34.
8. Chakrabarti G and Sen C (2011), Volatility Regimes and Calendar Anomaly in Foreign
Exchange Market, International Journal of Applied Economics and Finance, Vol. 5, No. 3,
pp. 97-113.
9. Charles A, Simon K and Daniel A (2008), Effect of Exchange Rate Volatility on Ghana
Stock Exchange, African Journal of Accounting, Economic, Finance and Banking Research,
Vol. 3, No. 3, pp. 28-47.
Exchange Rate Volatility Estimation Using GARCH Models,
with Special Reference to Indian Rupee Against World Currencies

35

10. Cont R (2001), Empirical Properties of Asset Returns: Stylized Facts and Statistical
Issues, Quantitative Finance, Vol. 1, No. 2, pp. 223-236.
11. Dickey D A and Fuller W A (1979), Distribution of the Estimators for Autoregressive
Time Series with a Unit Root, Journal of American Statistical Association, Vol. 74, No. 366,
pp. 427-431.
12. Diebold F X and Nerlolve M (1989), The Dynamics of Exchange Rate Volatility:
A Multivariate Latent Factor ARCH Model, Journal of Applied Econometrics, Vol. 4,
No. 1, pp. 1-21.
13. Enders W (2004), Applied Econometric Time Series, 2nd Edition, Wiley Series in Probability
and Statistics.
14. Engel C and West K D (2005), Exchange Rates and Fundamentals, Journal of Political
Economy, Vol. 113, No. 3, pp. 485-517.
15. Engle R (1982), Autoregressive Conditional Heteroskedasticity with Estimates of the
Variance of United Kingdom Inflation, Econometrica, Vol. 50, No. 4, pp. 987-1007.
16. Engle R and Patton A (2001), What Good is a Volatility Model?, Quantitative Finance,
Vol. 1, No. 1, pp. 237-245.
17. Evans M and Lyons R (2002), Order Flow and Exchange Rate Dynamics, Journal of
Political Economy, Vol. 110, No. 1, pp. 170-180.
18. Fama E F (1965), The Behaviour of Stock Market Prices, Journal of Business, Vol. 38,
No. 1, pp. 34-105.
19. Gallant A, Rossi P and Tauchen G (1992), Stock Prices and Volume, Review of Financial
Studies, Vol. 5, No. 2, pp. 199-242.
20. Glosten I R, Jagannathan R and Runkle D (1993), On the Relation Between the Expected
Value and the Volatility of the Normal Excess Return on Stocks, Journal of Finance,
Vol. 48, No. 5, pp. 1779-1801.
21. Guillaume D M, Dacorogna M M, Dave R M et al. (1997), From the Birds Eye to the
Microscope: A Survey of New Stylized Facts of the Intra-Daily Foreign Exchange
Market, Finance and Stochastics, Vol. 1, No. 2, pp. 95-129.
22. Jakaria S and Abdalla S (2012), Modelling Exchange Rate Volatility Using GARCH
Models: Empirical Evidence from Arab Countries, International Journal of Economics and
Finance, Vol. 4, No. 3, pp. 216-229.
23. Kaur H (2004), Time Varying Volatility in the Indian Stock Market, Vikalpa, Vol. 29,
No. 4, pp. 25-42.
24. Kwaiatkowski D P, Phillips C B, Schmidt P and Shin Y (1992), Testing the Null
Hypothesis of Stationarity Against the Alternative of a Unit Root, Journal of Econometrics,
Vol. 54, Nos. 1-3, pp. 159-178.
36

The IUP Journal of Applied Finance, Vol. 21, No. 1, 2015

25. Longmore R and Robinson W (2004), Modelling and Forecasting Exchange Rate
Dynamics: An Application of Asymmetric Volatility Models, Bank of Jamaica, Working
Paper WP2004/03.
26. Mandelbrot B (1963), The Variation of Certain Speculative Prices, Journal of Business,
Vol. 36, No. 4, pp. 394-419.
27. Miller E M (1984), Why a Weekend Effect?, Journal of Portfolio Management, Vol. 14,
No. 4, pp. 42-48.
28. Mishra A and Yadav R (2012), Exchange Rate Behaviour and Management in India:
Issues and Empirics, International Journal of Economics, Commerce and Research, Vol. 2,
No. 4, pp. 9-16.
29. Murari K (2013), Volatility Modeling and Forecasting for Banking Stock Returns,
International Journal of Banking, Risk and Insurance, Vol. 1, No. 2, pp. 17-27.
30. Nelson D (1991), Conditional Heteroskedasticity in Asset Returns: A New Approach,
Econometrica, Vol. 59, No. 1, pp. 347-370.
31. Phillips P C and Perron P (1988), Testing for a Unit Root in Time Series Regression,
Biometrika, Vol. 75, No. 2, pp. 335-346.
32. Rossi B (2013), Exchange Rate Predictability, availabe at http://www.crei.cat/people/rossi/
Rossi_ExchangeRatePredictability_Feb_13.pdf. Retrieved on October 17, 2013.
33. Schwert W (1989), Stock Volatility and Crash of 87, Review of Financial Studies,
Vol. 3, No. 1, pp. 77-102.
34. Shin J (2005), Stock Returns and Volatility in Emerging Markets, International Journal
of Business and Economics, Vol. 4, No. 1, pp. 31-43.
35. Taylor S (1986), Modelling Financial Time Series, John Wiley and Sons, Chichester.
36. Theobald M and Price V (1984), Seasonality Estimation in Thin Markets, Journal of
Finance, Vol. 39, No. 2, pp. 377-392.
37. West K and Cho D (1995), The Predictive Ability of Several Model of Exchange Rate
Volatility, Journal of Econometrics, Vol. 69, No. 2, pp. 367-391.
38. Zakoian J M (1994), Threshold Heteroscedastic Models, Journal of Economic Dynamics
and Control, Vol. 18, No. 5, pp. 931-944.
Reference # 01J-2015-01-02-01

Exchange Rate Volatility Estimation Using GARCH Models,

with Special Reference to Indian Rupee Against World Currencies

37

Copyright of IUP Journal of Applied Finance is the property of IUP Publications and its
content may not be copied or emailed to multiple sites or posted to a listserv without the
copyright holder's express written permission. However, users may print, download, or email
articles for individual use.