Common Volatility in the Foreign Exchange Market

The adverse effect of currency volatility on international trade has prompted the inception of the European Monetary System (EMS) and other measures of international policy coordination aimed at reducing intracurrency variability. Until "Black Wednesday" in September 1992 the EMS had some sucess in this objective, but following pressure on the Italian Lira, other ERM currencies (viz. Sterling, the Spanish Peseta, Portugese Escudos, Danish Kroner , Belgian Franc and the French Franc) have all experienced extremely volatile periods which culminated in the virtual break up of the EMS in August 1993, when all but the German Mark and Dutch Guilder moved to much wider bands. However speculative investment in over-the-counter derivatives (such as at-the-money straddles) does not help to reduce currency volatility. Regulation of OTC derivatives trading is now a major international concern, and the Basle committee meetings during 1993 have led to a new Capital Adequacy Directive of the European commission, which is now being enforced by national banks. In order to assess the extent of currency risks which are being taken in OTC derivatives trading, it is necessary to understand any common volatility factors in exchange rates. This is the purpose of the present paper. We ask whether intracurrency variability is dominated by regional factors (including association with the EMS), global factors, or speculative investment. An autoregressive conditionally heteroscedastic (ARCH) framework is employed for this analysis, and over limited periods a number of common conditionally heteroscedastic