Volatility impulse responses for multivariate GARCH models: An exchange rate illustration

We introduce a new concept of impulse response functions tracing the effects of independent shocks on volatility through time while avoiding typical orthogonalization and ordering problems. In an empirical study of a bivariate foreign exchange (FX) rate series we use volatility impulse response functions to discuss the effects of central bank decisions such as direct interventions in the FX-market or open market activities on FX market volatility. Comparing our concept with conditional moment profiles introduced by Gallant et al. [Gallant, A.R., Rossi, P.E., Tauchen, G., 1993. Nonlinear dynamic structures. Econometrica 61, 871-907], we show that for shocks affecting FX rates in an asymmetric way, the difference between the two methodologies and their interpretation can be substantial. (c) 2006 Elsevier Ltd. All rights reserved.