Modeling Exchange Rate Dynamics in Egypt: Observed and Unobserved Volatility

Abstract

The underlying study focuses on estimating and forecasting the volatility of exchange rate in Egypt based on ARCH type models and the State Space (SS) models, namely; the Stochastic Volatility (SV) and the Time-Varying Parameter (TVP) models. Moreover, the paper tests the predictive power of the conducted models to come up with a powerful technique that gives the best forward-looking stance of the exchange rate. Empirically, the paper utilizes daily exchange rate data spanning from January 2003 till June 2013. Evidently, it is found that the exchange rate returns in Egypt suffer from the volatility clustering phenomenon and that there exists a time-varying variance in the exchange rate series that has to be appropriately dealt with, while modelling nominal exchange rates. Additionally, with regard to the link between the volatility occurring in the stock market in Egypt and the volatility of the exchange rate market, it is found that there is a risk mismatch between the two markets. Therefore, further research is recommended in the future to suggest other exogenous variables that can help in explaining the volatility in the exchange rate returns in Egypt.