Have Exchange Rates Become More Closely Tied? Evidence from a New Multivariate GARCH Model

Abstract

We analyze the time-dependence of exchange rate correlations using a new multivariate GARCH model. This model consists of two parts. First, we transform the exchange rate changes into their principal components and specify univariate GARCH models for all components. Second, we use the inverse of the principal components construction to transform the conditional component moments back into those of the exchange rate changes themselves. The model is easy to estimate, as it requires only univariate GARCH estimations. Nevertheless, it outperforms the popular constant conditional correlations and factor GARCH models. We find that the major U.S. dollar exchange rates have become more loosely instead of closely tied since the eighties.

JEL Classification: C32, C52, F31