Idiosyncratic Volatility, Economic Fundamentals, and Foreign Exchange Rates

Abstract

This paper shows that a relatively high level of average U.S. industry- or firm-level idiosyncratic stock volatility is usually associated with a future appreciation in the U.S. dollar. For most foreign currencies, the relation is statistically significant in both in sample and out-of-sample tests, even after we use a bootstrap procedure to explicitly account for data mining. We also document a positive and significant relation between a country's idiosyncratic volatility and the future U.S. dollar price of its currency - in France, Germany, and Japan. Moreover, among a number of commonly used financial variables, only idiosyncratic volatility forecasts output growth in both U.S. and foreign countries. Our results suggest that there might be a close link between exchange rates and economic fundamentals.