Exchange rate returns and volatility: the role of time-varying rare disaster risks

ABSTRACT

This paper provides empirical evidence to the theoretical claim that rare disaster risks have predictability for exchange rate returns and volatility using a nonparametric quantile-based methodology. Using dollar-based exchange rates for Brazil, Russia, India, China, and South Africa, the quantile-causality test shows that indeed rare disaster-risks affects both returns and volatility over the majority of their respective conditional distributions. In addition, these effects are much stronger when compared to those using the British pound, especially in terms of currency returns.

KEYWORDS:

• Exchange rate returns and volatility
• rare disasters
• nonparametric quantile causality

JEL CODES:

• C22
• C58
• G14
• G15

Acknowledgement

We would like to thank an anonymous referee, the Associate Editor, and the Editor (Professor Christopher J. Adcock) for many helpful comments. However, any remaining errors are solely ours.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Note that, the disaster risk variable Wars also has a significant causal impact on volatility at the quantile of 0.75.

2. Based on the suggestion of the Associate Editor, we repeated the analysis using alternative measures of rare disaster risks. In this regard, we used the news-based indexes of total geopolitical risks, and the same due to acts and threats, as recently developed by Caldara and Iacoviello (2018), details of which can be found at: https://www2.bc.edu/matteo-iacoviello/gpr.htm. Caldara and Iacoviello (2018) construct monthly indices of GPRs by counting the occurrence of words related to geopolitical tensions in three leading international newspapers (The New York Times, the Chicago Tribune, and the Washington Post). The authors search for articles containing references to words associated with: explicit mentions of geopolitical risk, as well as mentions of military-related tensions involving large regions of the world and a U.S. involvement; nuclear tensions; war threats and terrorist threats; actual adverse geopolitical events (as opposed to just risks) which can be reasonably expected to lead to increases in geopolitical uncertainty, such as terrorist acts or the beginning of a war. Our results were qualitatively similar to those reported in the paper, and are available upon request from the authors.

3. This analysis is based on the suggestion of the Associate Editor.

4. We would like to thank the Associate Editor for guiding us in this direction.