A Stochastic Model for Variation of Exchange Rates in Sri Lanka

Abstract

In Sri Lankan economy, exchange rates have been a one of the critical factors as domestic inflation mostly occurs on depreciation of currency value. Exchange rate is the rate at which currency of a country is bought and sold against the currency of another country in the foreign exchange market. In this work, buying price of the US dollar has been used as a better yardstick to analyze the exchange rates in Sri Lanka as US dollar is being concerned as a world most accepted trade denominator and its buying price was used as purchasing power of the Sri Lankan rupee is deteriorating. The main objectives of this analysis are to derive a stochastic model to represent the variation of exchange rates and hence make conclusions about the variation. Vasicek model was used to model the variation of exchange rates as variation of exchange rates is a stochastic process and there is a mean reversion. Vasicek model is the first stochastic model to capture the value of mean reversion. The model describes the dynamics of the short rate in a linear equation and short rates can be solved explicitly. In this analysis, using daily authentic data from 2005 to 2012 and maximum likelihood estimation, parameters of the Vasicek model were derived. According to the final model, exchange rate is fluctuating around the value Rs.108.3488 and there is an ascent of the variation. Therefore, it is clear that currency value is deteriorating and hence, investors have to pay more money to import their products. Then this additional cost has to be covered by enhancing price levels inside the country. In order to control the depreciation of currency value government intervention is needed. Improvement of the gross domestic product can be concerned as a best economic strategy to regulate the depreciation of currency value.