Forecasting realized exchange rate volatility by decomposition

We compare forecasts of the realized volatility of the exchange rate returns of the Euro against the U.S. Dollar and the Japanese Yen obtained both directly and through decomposition. Decomposing the realized volatility into its continuous sample path and jump components, and modeling and forecasting them separately instead of directly forecasting the realized volatility, is shown to lead to improved out-of-sample forecasts. Moreover, the gains in forecast accuracy are fairly robust with respect to the details of the decomposition, but the jump component should probably not be defined too tightly. © 2007 International Institute of Forecasters. Published by Elsevier B.V. All rights reserved.