The Interrelationship of Return and Volatility between Exchange Rate and Financial Variables

Abstract

The purpose of this research is to explore the relationship between exchange rate and 12 financial variables in order to find useful implications to predict the movement of short-term exchange rate. As a result of using various analytical techniques such as univariate GARCH, VAR, multivariate GARCH, cointegration, and VECM, we found some valuable information on exchange rate movement. First, the KOSPI is considered as the most useful financial variable affecting short-term exchange rate changes. Second, CDS premium, S&P500, and foreign net stock buying are also meaningful variables that affect the short-term exchange rate. Third, when the Korean won depreciates, factors of instability in the domestic financial market (i.e., falling stock price, rising stock market risk, and rising country default risk) also accompany such currency depreciation. When the won appreciates, the dollar value depreciates relative to major countries’ currencies. Fourth, the volatility of the dollar index is the only variable that affects the volatility of the exchange rate. Fifth, the CDS premium is the most useful financial variable affecting long-term exchange rate changes since the CDS premium and exchange rate are in long-term equilibrium relationship. The exchange rate, not the CDS premium, adjusts for deviation from the long-term equilibrium.