FX Comovements: Disentangling the Role of Market Factors, Carry-Trades and Idiosyncratic Components

Abstract

This paper models high and low frequency dynamic components of FX excess return correlations and examines their relationship with economic fundamentals. A factor currency pricing model is used to characterize the correlation structure of FX excess returns. I provide evidence on high levels of comovement in FX markets during the post-crisis (or recovery) period following the 2008 financial turmoil. I find that while the low frequency component of systematic volatility shows an increasing trend during this recent period, the low frequency component of idiosyncratic volatilities presents declining patterns. These two effects explain the increase in average long-term correlations. In terms of idiosyncratic effects, my results suggest that country-specific inflation levels and real output growth significantly affect the time-series and cross-sectional variation of long-term FX idiosyncratic volatilities.