The Impact of Sovereign Yield Curve Differentials on Value-at-Risk Forecasts for Foreign Exchange Rates

Abstract

A functional ARMA-GARCH model for predicting the value-at-risk of the EURUSD exchange rate is introduced. The model implements the yield curve differentials between EUR and the US as exogenous factors. Functional principal component analysis allows us to use the information of basically the whole yield curve in a parsimonious way for exchange rate risk prediction. The data analyzed in our empirical study consist of the EURUSD exchange rate and the EUR- and US-yield curves from 15 August 2005–30 September 2016. As a benchmark, we take an ARMA-GARCH and an ARMAX-GARCHX with the 2y-yield difference as the exogenous variable and compare the forecasting performance via likelihood ratio tests. However, while our model performs better in one situation, it does not seem to improve the performance in other setups compared to its competitors.