An investigation into the determinants of exchange rate volatility

Abstract

Exchange rate volatility has significant effects on decisions made by many economic agents who participate in foreign exchange markets, most notably exporters, importers and foreign investors. The literature in the field of international macroeconomics has mainly concentrated on changes in the level of exchange rates rather than exchange rate volatility itself. Since we believe that the second moment of the exchange rate should be given more attention, we directly investigate the relationship between exchange rate volatility and macroeconomic fundamentals in developed as well as developing countries. For this reason, from the traditional exchange rate models which relate exchange rate levels to a set of fundamentals, we derive equations that can be used to examine the determinants of exchange rate volatility. We also investigate the possible impact of different variability measures and data frequencies. Our empirical results are generated from a very recently developed approach to cointegration analysis, namely, the bounds testing method of Pesaran et al., 2001. Using four industrialized countries and four less developed countries over the period 1973 to 1998, we found that the volatility of some macroeconomic fundamentals does indeed have a significant impact on the volatility of exchange rates in both groups of countries. Finally, whilst different variability proxies and data frequencies slightly affect the signs of significant variables, they do highly impact on the significance and weight that should be given to the relevant fundamental.