A Copula-Based Approach for Modelling the Dependence between Inflation and Exchange Rate in Kenya

Abstract

In this study, we modeled the dependence structure between inflation and exchange rate using the copula approach. To formulate a bivariate copula, we used ARMA+GARCH to model serial dependence for each univariate series of returns. Both for in ation and exchange rate, it was found that the student t distribution was the best marginal distribution. Then, we transformed the standardized residuals from those marginal distributions (student t) into uniform over the range [0; 1]. To estimate the copula, we used a parametric approach. Gumbel copula was found to be the best to capture the dependence. We investigated the time-varying dependence using change-point detection based on copula. We found that there is a significant change in the nature of dependence over the period under consideration. The change in the nature of dependence between the two variables was in line with the prevailing macro-economics conditions during the period under review. We recommend to the future researchers to consider studying time-varying dependence between those two variables and investigate also the change in copula parameters in values with time. We also recommend including other macroeconomic variables while modeling the relationship between in ation and exchange rate.