Spread and volatility in spot and forward exchange rates

Abstract

This paper is concerned with modeling the conditional heteroscedasticity of the prediction error of foreign exchange rates. As spot and forward rates are cointegrated we use a system of error correction models for mean prediction. To predict the variance we use a vibariate generalized autoregressive conditional heteroscedasticity (GARCH) model as a function of the spread. Using daily series for seven currencies, we find that unmodeled conditional heteroscedasticity by GARCH can generally be explained by the squared spread. This indicates that as the spread is bigger the exchange rates are more volatile. (JEL F31, C32).