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Estimating volatility transmission between oil prices and the US Dollar exchange rate under structural breaks

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Abstract

This study examines volatility dynamics of oil prices and the US dollar exchange rate using univariate and bivariate GARCH models using data from January 2, 2000 to December 31, 2015. The modified iterative cumulative sum of square (ICSS) algorithm is employed to identify structural breaks in the variance of the two return series. I find no evidence of volatility transmission between oil prices and the US dollar exchange rate if structural breaks are ignored in the model. However, after accounting for structural breaks in variance in the bivariate GARCH model, I find significant volatility transmission between oil prices and the US dollar exchange rate. I also show that dynamic risk minimizing hedge ratios substantially change when breaks are incorporated in the bivariate GARCH model.

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Notes

  1. Rapach and Strauss (2008) have used the exact same methodology to detect structural breaks and readers can consult their paper for a detailed description of the methodology.

  2. The frequency, span and time period of the sample was selected to be consistent with earlier relevant studies as most of them have used 15 years of recent daily data.

  3. My results are based on in-sample forecast, which has limited practical implication. A pure out-of-sample forecast would require re-estimating the model in-sample and projecting the variances one-step-ahead, where each step requires re-identifying the breaks and re-estimating the bivariate GARCH model. This exercise is beyond the scope of my paper but would be a good avenue of future research.

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Acknowledgements

Comments from Bradley Ewing, Farooq Malik and Michael Noel are greatly appreciated. Any remaining errors are my own.

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  1. Department of Economics, Texas Tech University, Lubbock, TX, 79409, USA

    Hassan Anjum

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  1. Hassan Anjum
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Correspondence to Hassan Anjum.

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Anjum, H. Estimating volatility transmission between oil prices and the US Dollar exchange rate under structural breaks. J Econ Finan 43, 750–763 (2019). https://doi.org/10.1007/s12197-019-09472-w

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