U.S. unconventional monetary policy and risk tolerance in major currency markets

Abstract

This paper studies the effects of U.S. unconventional monetary policy announcements on the implied volatility of three major currency pairs, Dollar/Euro, Dollar/British Pound and Dollar/Yen by using panel data analysis along with several model specifications and robustness tests. Monetary policy announcements not only have an effect on the realized behavior of asset prices, but also influence market participants’ expectations regarding future volatility. Our empirical findings show that Federal Reserve’s unconventional monetary policy announcements significantly reduce the market expectations about future realized volatility of exchange rates, suggesting that lax monetary policy leads to elevated risk-tolerance in currency markets. Furthermore, our findings indicate that market participants’ expectations respond differently to the different rounds of U.S. quantitative easing.

KEYWORDS:

• Unconventional monetary policy
• implied volatility
• foreign exchange market
• panel data

Subject classification codes:

• C50
• E52
• E58

Acknowledgements

The authors would like to thanks the participants of the 9th International Conference of the Financial Engineering and Banking Society, the Editor, the guest editors of the special issue, as well as the three anonymous referees of this journal, for their helpful comments. Any unintended errors or omissions are our own doing.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 CBOE also publishes, from 2008, the CBOE EuroCurrency ETF Volatility Index (EVZ), which is based on CurrencyShares Euro Trust (FXE) options.

2 For a survey using meta-regression analysis on QE effects on output and inflation, see Papadamou, Kyriazis, and Tzeremes (2019).

3 The data that support the findings of this study are available from the corresponding author upon reasonable request.

4 We also repeat the impulse response analysis using the panel VAR model and the narrower estimation window around unconventional monetary policy events, but the results (not reported here for economy of space reasons) confirm our central results.