Interest rate volatility, exchange rates, and external contagion

Abstract

US interest rate volatility and contagion effects (propagation of crises) are investigated using GARCH equations over the period 1993.01–1998.12. The period includes two main financial crises: the 1994 Mexican peso crisis and the 1997 Japanese yen crisis. Contagion is more likely to occur in cointegrated markets with available open channels. The purchasing power and interest parities' channels suggest that the domestic inflation rate reflects some influence of the foreign exchange rate. The results indicate that, although the bulk of the US interest volatility is idiosyncratic, spillovers from Mexican exchange rate changes are more likely to induce contagion effects on US interest rates than Japanese exchange rates, possibly because of increased capital flows after NAFTA. Further, unlike the floating rate of Japan, the Mexican fixed exchange rate encourages international capital flows.