Macroeconomic news surprises and volatility spillover in foreign exchange markets

Abstract

This paper examines the link between exchange rate volatility and economic fundamentals. In the framework of a multivariate volatility model that allows volatility spillover, we develop a new impulse response analysis to estimate and decompose the simultaneous effect of macroeconomic news surprises on the foreign exchange volatility. We show that news announcement effects include two components: a direct and an indirect effect induced by volatility spillover. We show that more than 50 % of the total accumulated news effect on the Pound and the Yen is due to volatility transmission from the two major currencies and mainly from the Euro.

Appendix

For the volatility impulse response function in (10), straightforward matrix calculus yields the following results: $\partial V_{kl}/\partial \omega ' = 0$, $\partial V_{kl}/\partial \varphi _l' = (A+B)^{k-1} + \sum _{j=0}^{k-2} (A+B)^j(C_l-B)C_l^{k-j-2}$, $\partial V_{kl}/\partial \varphi _r' = 0$, $r \ne l$,

$$\begin{aligned} \frac{\partial V_{kl}}{\partial \text{ vec }(A)'}&= (\varphi _l'\otimes I_N)\sum _{i=0}^{k-2} (A'+B')^{k-2-i}\otimes (A+B)^{i}\\&+ \sum _{j=1}^{k-2}(d_{lj}'\otimes I_N)\sum _{i=0}^{j-1} (A'+B')^{j-1-i}\otimes (A+B)^{i}\\ \frac{\partial V_{kl}}{\partial \text{ vec }(B)'}&= \frac{\partial V_{kl}}{\partial \text{ vec }(A)'} + \sum _{j=0}^{k-2}(\varphi _l'C_l^{\prime k-j-2} \otimes (A+B)^j) \\ \frac{\partial V_{kl}}{\partial \text{ vec }(C)'}&= \sum _{j=0}^{k-2}(\varphi _l' \otimes (A+B)^j(C_l-B)) \sum _{i=0}^{k-j-3}(C^{\prime k-j-3-i}\otimes C^i) \\&+\,\, (\varphi _l'C^{\prime k-j-2}\otimes (A+B)^j) \end{aligned}$$

where $\otimes$ is the Kronecker product operator and $d_{lj} = (C_l-B)C_l^{k-j-2}$. These results can be used to construct pointwise confidence bands for the estimated volatility impulse response functions.