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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page A Utility Based Comparison of Some Models of Exchange Rate Volatility
Kenneth D. West, Hali J. Edison, and Dongchul Cho
1993-441  (February 1993)

Abstract:  When estimates of variances are used to make asset allocation decisions, underestimates of population variances lead to lower expected utility than equivalent overestimates: a utility based criterion is asymmetric, unlike standard criteria such as mean squared error. To illustrate how to estimate a utility based criterion, we use five bilateral weekly dollar exchange rates, 1973-1989, and the corresponding pair of Eurodeposit rates. Of homoskedastic, GARCH, autoregressive and nonparametric models for the conditional variance of each exchange rate, GARCH models tend to produce the highest utility, on average. A mean squared error criterion also favors GARCH, but not as sharply.

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