Long memory cointegration and dynamic connectedness of volatility in US dollar exchange rates, with FOREX portfolio investment strategy

Isaac O. Ajao; Hammed A. Olayinka; Moruf A. Olugbode; OlaOluwa S. Yaya; Olanrewaju I. Shittu; Isaac O. Ajao; Hammed A. Olayinka; Moruf A. Olugbode; OlaOluwa S. Yaya; Olanrewaju I. Shittu

doi:10.3934/QFE.2023031

Quantitative Finance and Economics

2023, Volume 7, Issue 4: 646-664. doi: 10.3934/QFE.2023031

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Research article

Long memory cointegration and dynamic connectedness of volatility in US dollar exchange rates, with FOREX portfolio investment strategy

1.
Department of Statistics, Federal Polytechnic, Ado-Ekiti, Nigeria
2.
Department of Mathematical Sciences, Worcester Polytechnic Institute, Worcester, USA
3.
National Bureau of Statistics, Ibadan, Nigeria
4.
Economic and Financial Statistics Unit, Department of Statistics, University of Ibadan, Ibadan, Nigeria

Received: 24 October 2023 Revised: 06 December 2023 Accepted: 10 December 2023 Published: 18 December 2023
JEL Codes: C22, C31, F31

Decisions of central banks on foreign exchange rates are based on the comovement of foreign exchange (FOREX) in mature markets such as US dollar rates to the British pound, euro, Chinese yuan, Japanese yen and Australian dollar. We investigate the long-run movement and dynamic quantile connectedness of volatility among pairs of these exchange rates. The updated residual-based fractional cointegration testing framework using narrow-band frequency domain least squares estimator is used to obtain the residual series for fractional cointegration. Quantile dynamic connectedness framework for volatility spillovers at different market conditions, depicted by quantiles, are used. We find evidence of long memory cointegration in seven pairs of exchange rates involving the previously mentioned currencies. These seven cases also correspond to a higher average index of quantile connectedness, with the effect of connectedness phasing out at higher quantiles and being more visible at lower quantiles. A portfolio investment strategy using optimal portfolio weights and hedge ratios for maintaining the accrued profit at the FOREX market is also presented.
- exchange rate volatility,
- Narrow-band frequency domain least squares,
- long memory cointegration,
- quantile connectedness,
- portfolio investment strategy
Citation: Isaac O. Ajao, Hammed A. Olayinka, Moruf A. Olugbode, OlaOluwa S. Yaya, Olanrewaju I. Shittu. Long memory cointegration and dynamic connectedness of volatility in US dollar exchange rates, with FOREX portfolio investment strategy[J]. Quantitative Finance and Economics, 2023, 7(4): 646-664. doi: 10.3934/QFE.2023031

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Abstract

Decisions of central banks on foreign exchange rates are based on the comovement of foreign exchange (FOREX) in mature markets such as US dollar rates to the British pound, euro, Chinese yuan, Japanese yen and Australian dollar. We investigate the long-run movement and dynamic quantile connectedness of volatility among pairs of these exchange rates. The updated residual-based fractional cointegration testing framework using narrow-band frequency domain least squares estimator is used to obtain the residual series for fractional cointegration. Quantile dynamic connectedness framework for volatility spillovers at different market conditions, depicted by quantiles, are used. We find evidence of long memory cointegration in seven pairs of exchange rates involving the previously mentioned currencies. These seven cases also correspond to a higher average index of quantile connectedness, with the effect of connectedness phasing out at higher quantiles and being more visible at lower quantiles. A portfolio investment strategy using optimal portfolio weights and hedge ratios for maintaining the accrued profit at the FOREX market is also presented.

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