Volatility Clustering and Leverage Effect in the Indian Forex Market

Abstract

Understanding the patterns of volatility in financial assets is immensely useful in portfolio management process. They are the critical inputs for portfolio selection, asset allocation, asset pricing, portfolio diversification and risk management. This study examines the phenomenon of volatility clustering and leverage effect in exchange rates of four major currencies, namely, US dollar (USD), euro, Japanese yen and pound sterling vis-à-vis Indian rupee (INR) from the vantage point of view of volatility modelling and to assess the forecasting ability using generalized autoregressive conditional heteroskedasticity (GARCH)-class models. Besides, it evaluates the models in terms of out-of-sample forecast accuracy. The study spans for a period of 13 years from 3 January 2000 to 31 December 2012. GARCH (1, 1), exponential GARCH (EGARCH) (1, 1), threshold autoregressive conditional heteroskedasticity (TARCH) (1, 1) and power ARCH (1, 1) models are used in this context. The results show the existence of volatility clustering. No significant leverage effects were evident. Volatility seems to be persistent in nature.