Abstract
How strongly are foreign exchange markets linked in terms of their similarities in long-run fluctuations? Are they cointegrating? To analyze such “comovements,” we present a time-varying cointegration model for the foreign exchange rates of the currencies of Canada, Japan, and the UK vis-à-vis the U.S. dollar from May 1990 through July 2015. Unlike previous studies, we allow the loading matrix in the vector error-correction (VEC) model to be varying over time. Because the loading matrix in the VEC model is associated with the speed at which deviations from the long-run relationship disappear, we propose a new degree of market comovement based on the time-varying loading matrix to measure the strength or robustness of the long-run relationship over time. Since exchange rates are determined by macrovariables, cointegration among exchange rates implies these variables share common stochastic trends. Therefore, the proposed degree measures the degree of market comovement. Our main finding is that the market comovement has become stronger over the past quarter-century, but at a decreasing rate with two major turning points: one in 1995 and the other one in 2008.
Highlights
It is well understood among researchers that exchange rate dynamics are highly complex, and there is little consensus on which econometrics model best describes the time-series process of exchange rates
By allowing α to be time-varying, we capture the time-varying nature of market comovement by estimating the change in the matrix over time using the time-varying vector error-correction (VEC) model ( cointegration in foreign exchange rates does not mean that foreign exchange markets are efficient per se (See Engel [9]), it is possible to interpret α as the speed at which arbitrage occurs in some cases
Instead of presenting detailed estimates about our time-varying VEC model, we report the degree of adjustment speed ζ t
Summary
It is well understood among researchers that exchange rate dynamics are highly complex, and there is little consensus on which econometrics model best describes the time-series process of exchange rates. Our attempt in this paper is to estimate the extent to which exchange rates move together in the long run, considering the possibility that the cointegrating relationship may not be stable over time presumably owing to a time-varying market environment. In this way, we can shed new light on the debate on whether cointegrating relations exist in foreign exchange rates. As the following subsections explain, the crux of our model is that the adjustment process or the speed of adjustment to the long-run relationships can vary over time, reflecting the changing environment in the global foreign exchange markets
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