SPREAD AND VOLATILITY IN SPOT AND FORWARD EXCHANGE-RATES

This paper is concerned with modeling the conditional heteroscedastici ty of the prediction error of foreign exchange rates. As spot and forw ard rates are cointegrated we use a system of error correction models for mean prediction. To predict the variance we use a bivariate genera lized autoregressive conditional heteroscedasticity (GARCH) model as a function of the spread. Using daily series for seven currencies, we f ind that unmodeled conditional heteroscedasticity by GARCH can general ly be explained by the squared spread. This indicates that as the spre ad is bigger the exchange rates are more volatile. (JEL F31, C32).