FX Comovements and their Economic Determinants
54 Pages Posted: 8 Jun 2011 Last revised: 7 Oct 2020
Date Written: September 24, 2020
This paper models high and low frequency dynamic components of FX excess return correlations and examines their relationship with economic fundamentals. A factor currency pricing model with time-varying factor loadings is used to characterize the correlation structure of FX excess returns. Aggregate FX comovement is countercyclical as it is positively related to U.S. economic policy uncertainty and negatively related to global GDP growth. The level of comovement is lower in developing countries due to differentiated patterns in their idiosyncratic volatilities. Indeed, country-specific inflation levels and real output growth only impact idiosyncratic volatilities in developing economies. Monetary policy (rates), trade and capital flows affect all currencies.
Keywords: Conditional comovements, FX markets, global factors, time-varying loadings, idiosyncratic volatilities, trends, economic fundamentals
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation