Systematic variations in exchange rate returns

Abstract

This paper explores the latent factor structure of systematic variations in exchange rate returns among 43 currencies from 2001 to 2017. The exchange rate return variation is decomposed into a world factor, group factor and country-specific factor by employing a dynamic factor model. We find that the world factor is the main driving force in exchange rate return variation in industrialized and European emerging market economies (EME). Based on the Lasso family methods, this study finds that the relationship between the systematic variations in exchange rate returns and economic fundamentals has changed over the observation period.