A conditional variance tale from an emerging economy's freely floating exchange rate

Abstract

This article studies daily return and volatility dynamics in the exchange rate of an emerging market economy Turkey over the recent floating period. We use Generalized Autoregressive Conditional Heteroscedastic (GARCH) and Fractionally Integrated GARCH (FIGARCH) models with various error distributions. Findings show that a parsimonious FIGARCH model with an asymmetric error distribution characterizes the daily Turkish Lira (TL) returns against US dollar and euro considerably well. We find statistically significant asymmetry and peakedness in conditional returns and time-varying volatility with long-range dependence in conditional volatility. Long memory finding is robust to different specifications for the conditional returns as well as possible shifts in the return and volatility dynamics over sub-periods. Results in the article show that despite the decline in volatility over the course of the recent float, TL returns are still wild compared to developed economies exchange rates during the same period. Findings have implications for exchange rate regime choice, policy and risk management in Turkey and other emerging market economies.