The Roles of Futures Trading in Exchange Rate Volatility

Abstract

This study examines the relationship between the level of futures trading activity in five currencies and the variability in the underlying exchange rate changes. The conditional variance from the GARCH model is employed as the proxy for the exchange rate volatility. The evidence indicates that futures trading has a significant impact on the volatility in the exchange rates, with a weaker feedback from exchange rate volatility to futures trading. The causal patterns that emerge are also symptomatic of overreaction in exchange rate changes to shocks in futures trading. The positive impact of futures trading activity on exchange rate volatility is found to persist over several trading days, at least during periods of major change in the level of future trading activity. On the other hand, futures trading is found to decline on the day following increased volatility in spot rates.

JEL Classification: G15, F31