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I want to estimate/predict the volatility of the currency exchange rate. I have checked in literature a few models from very simple PPP to econometric factor model forecasting, to GARCH (for univariate), to DCC (dynamic conditional correlation for multivariate). Are there more suitable models? if yes may you mention them and indicate some references? Currently my choice would be to go for a factor model of the exchange rate because it seems to me a not too simple and not too complicated thing to implement. However I would like some advices. Thanks

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Probably your best approach is to use something like a GARCH-X model. That gives you a GARCH setup to capture the persistence of volatility; however, you also bring in other exogenous-ish covariates to better model the mean and/or volatility. That would allow you to bring in (for example) the size of interest rate parity violations, PPP, change in PPP, productivity differences, and more.

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  • $\begingroup$ interesting, thanks. Have you got any reference especially in terms of python implementation? $\endgroup$
    – Luigi87
    Jul 24 '20 at 7:07
  • $\begingroup$ No, sorry. There may be a python implementation, but I know many models are not available in python -- so you may need to use another modeling language. $\endgroup$
    – kurtosis
    Jul 24 '20 at 7:33
  • $\begingroup$ in case I want to use it to predict the EUR/GBP volatility rate. I have two questions: do I need to transform the level (downloaded value from bloomberg) to a return or keep it as a level? also in this was (univariate) the effect of other currencies exchange rate seems not to affect..like if EUR/USD change maybe also EUR/GBP changes..is there a way to include in the GARCH X also the effect of other rates? thanks $\endgroup$
    – Luigi87
    Jul 24 '20 at 8:17

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