Abstract
Exchange rates and monetary policies are key tools in economic management and in the stabilization and adjustment process in developing countries, where low inflation rates and international competitiveness have become major policy targets. The study modelled the volatility of the US dollar against the Kenyan shilling (USD/KES) exchange rate and investigated the effect of inflation rates in Kenya on this volatility for the years 2005 to 2017. The data for this research was obtained from secondary sources: Central Bank of Kenya and the Kenya National Bureau of Statistics. The results indicated that the USD/KES exchange rate exhibited persistent signs of volatility. A number of heteroscedasticity models were then tested and the GARCH family (ARMA (1, 3)/EGARCH (1, 2)) model was concluded to be the best model to fit the volatility of the USD/KES exchange rate. The study tested the forecasting power of this model by comparing in-sample and out of sample observations and comprehensive conclusions were made that the model was the best fit to forecast the volatility of the USD/KES exchange rate. The volatility figures of the USD/KES exchange rate were extracted from the EGARCH model and further tests were conducted to investigate the effect of Kenyan inflation rates on them. Weighted Least Squares regression was conducted on the Kenyan inflation rates and volatility of the USD/KES exchange rate and comprehensive conclusions were made that there existed a significant relationship between the Kenyan inflation rates and the volatility of the USD/KES.
Highlights
An exchange rate is the price of one nation’s currency as compared to another nation’s currency and is usually determined in the foreign exchange market
This paper investigated the best model to capture the US dollar against the Kenyan shilling (USD/KES) exchange rate volatility in Kenya for the years 2005 to 2017
After carrying out various statistical tests to check for the best model to fit the returns, the study concluded that volatility was persistent and identified the Autoregressive Moving Average (ARMA) (1, 3)/Exponential Generalized Auto Regressive Conditional Heteroscedasticity (EGARCH) (1, 2) as the best model fit for the data
Summary
An exchange rate is the price of one nation’s currency as compared to another nation’s currency and is usually determined in the foreign exchange market. A free-floating currency implies that the exchange rate is determined by market forces (demand and supply), varies against other currencies. In such cases, the exchange rate changes constantly as determined by the financial markets. A movable/ adjustable peg currency implies that the exchange rate is fixed but has a provision for revaluation. When governments keep this currency in a narrow range, the currencies tend to be over or under valued lead to excessive trade deficits or surpluses
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