Neglected Common Factors in Exchange Rate Volatility

Ronald Mahieu and Peter Schotman

CEPR Financial Markets Paper from European Science Foundation Network in Financial Markets, c/o C.E.P.R, 33 Great Sutton Street, London EC1V 0DX.

Abstract: The paper proposes a new multivariate model for exchange rate volatility in a system of bilateral exchange rates, using a factor structure of exchange rates one of the common factors is always related to the numeraire currency. Time variation in the volatility is modelled using a stochastic variance approach. The interpretation of the factors provides a new way of estimating risk premia in the foreign exchange market. Empirical results show considerable volatility spillovers among the four major currencies. Risk premia show a major sign reversal for the dollar risk premium around 1978.

Keywords: Stochastic Volatility; Exchange Rates; Factor Models; Risk Efficiency; Competitive Market Making; Rational Expectations (search for similar items in EconPapers)
Date: 1994-01
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