Working Paper: CEPR ID: DP17101
Authors: Riccardo Colacito; Mariano Massimiliano Croce; Yang Liu; Ivan Shaliastovich
Abstract: Lack of co-movement between consumption differentials and real exchange rates is a traditional indicator of a disconnect of foreign exchange markets from economic fundamentals. We present novel evidence for the (dis)connect between the volatilities, as opposed to the levels, of these variables. The volatility correlations are below one, but they are larger than the level correlations. In the cross-section of countries, the volatility disconnect weakens for countries with low amount of expected growth risk and high amount of volatility risk. We provide an explanation of our empirical findings based on international risk-sharing of both expected growth and volatility news shocks.
Keywords: volatility; risk; foreign exchange disconnect; risk sharing
JEL Codes: C62; F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| correlation of conditional volatilities (C10) | correlation of levels of consumption growth differentials and exchange rates (F62) |
| relative unconditional volatility of expected output growth rates (C29) | volatility correlations (C10) |
| relative amount of time-varying volatility of each country pair (F31) | volatility correlations (C10) |
| higher risk of expected output growth (O49) | lower volatility correlations (C10) |
| greater volatility risk across countries (G15) | higher volatility correlations (C10) |