Abstract
This paper examines cross-country currency variations using principal components and a dynamic linear model (DLM). A combination of the principal components analysis and DLM (which is time-dependent) ensures that the variation explained by the analysis is non-static. Normally, ordinary principal components calculations produce static values that are not time-dependant. However, the dependence of spot and forward rates on time requires that a time-dependent modeling approach be adapted. The main argument in this analysis is that if countries have similar growth trends, then they are more likely to share common dominant growth factors. These factors could include, for instance, common inflation or currency risks. If this risk is significant enough then principal components analysis together with an appropriate DLM should capture it.
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