Modeling Returns and Volatility Transmission from Crude Oil Prices to Leone-US Dollar Exchange Rate in Sierra Leone: A GARCH Approach with Structural Breaks

Abstract

This paper sought to shed light on the impact of shocks to global oil prices on the Leone/US Dollar exchange rate in Sierra Leone during the post war period spanning 2002M6 to 2020M5. To achieve this, the paper employed the GARCH family models with structural breaks. After establishing the existence of ARCH effects and ensuring stationarity of the data set, the paper first applied both GARCH (1, 1) and GARCH (1, 1) in Mean models to capture the symmetry effect of global oil prices increase on exchange rate. Furthermore, the paper employed exponential GARCH (EGARCH (1, 1)) model to capture the asymmetric impact of oil price increase on the Leone/US Dollar exchange rate. Among the three models estimated, the EGARCH (1, 1) model was found to have the best fit as all of its mean and variance coefficients were not only found to be statistically significant but also had the least values of the model selection criteria. The empirical results suggest that an increase in oil price leads to depreciation of the exchanges rate in Sierra Leone and that exchange rate volatility exhibits persistence and autoregressive behavior. Furthermore, the paper finds evidence of asymmetry, indicating that positive shocks to crude oil prices will lead to a higher volatility in the exchange rate than negative shocks of the same magnitude. Finally, the paper finds evidence of structural breaks in the exchange series. The main policy implication from these findings is that the monetary authority should consider global oil price dynamics and the past history of exchange rate movements when formulating policy responses to exchange rate volatility in Sierra Leone.