Volatility (Dis)Connect in International Markets

Abstract

Lack of co-movement between consumption differentials and real exchange rates is a traditional indicator of a disconnect of foreign exchange markets from economic fundamentals. We present novel evidence for the (dis)connect between the volatilities, as opposed to the levels, of these variables. The volatility correlations are below one, but they are larger than the level correlations. In the cross-section of countries, the volatility disconnect weakens for countries with low amount of expected growth risk and high amount of volatility risk. We provide an explanation of our empirical findings based on international risk-sharing of both expected growth and volatility news shocks.

Keywords: foreign exchange disconnect, Risk Sharing, volatility risk

JEL Classification: C62, F31, G12