Enhancing Forecast Accuracy of Exchange Rate Volatility Using Hybrid ANN-GARCH Models: Evidence from South Africa, Brazil, and China

Abstract

An important development in the modelling of exchange rate volatility is the use of artificial neural networks (ANN) to create enhanced generalised autoregressive conditional heteroskedasticity (GARCH) models. Conventional GARCH models are good at capturing the clustering of volatility in financial time series, but they have trouble understanding complex linkages and non-linear patterns in the data. This paper aims to investigate the hybrid approach in modelling exchange rate volatility of two currency pairs: South African Rand against Brazilian Real (ZAR/REAL) and South African Rand against Chinese Yuan (ZAR/YUAN) using monthly observations over the period of January 1996-March 2024. The paper introduced ANN as an additional factor to both symmetric and asymmetric GARCH models that capture most common stylised facts about exchange rate volatility and leverage effects. The GARCH (1,1)-ANN, EGARCH (1,1)-ANN, and GJR-GARCH (1,1)-ANN models were used, and their performance was assessed using mean squared error (MSE), mean absolute error (MAE), and mean absolute percentage error (MAPE). The results revealed that the EGARCH (1,1)-ANN model had the best overall performance when compared to the other hybrid models based on all three evaluation measures for both the currency pairs’ data. The paper recommends further similar studies to predict future exchange rate trends and also incorporating other nonlinear methods.