Jump-diffusion processes in the foreign exchange markets and the release of macroeconomic news

Abstract

This study provides an examination of the effect of public news on inter-day exchange-rate return volatility. Unlike previous studies, the impacts ofboth U.S. and foreign macroeconomic news announcements are examined in the currency futures market for the Japanese yen, British pound, and Deutsche mark. Diffusion and jump-diffusion process models are developed which contain parameters conditional on the release of news. These models are estimated using the method of maximum likelihood, and are tested versus unconditional diffusion and jump-diffusion models using likelihood ratio tests. The results reveal that conditional variance diffusion and jump-diffusion process models dominate the equivalent non-conditional models. Over the period studied (January 1988–December 1990) U.S. merchandise trade balance and industrial production announcements had a significantly greater impact on trading period volatility than money supply or inflation announcements did. Foreign news was also found to have a substantially lower effect on foreign trading-period variance than U.S. news had on U.S. trading period variance. In addition, the correlation between the yen, pound, and mark was highest on days of U.S. macroeconomic news. Thus, this study provides evidence that the currency return generating process is not characterized by a simple diffusion process over trading and non-trading periods. Further, the release of U.S. and foreign macroeconomic news has been shown to provide additional understanding of the currency return process over and above that of more complex models such as a jump-diffusion process.