Uncertainty and Exchange Rate Volatility: The Case of Mexico

Abstract

This paper investigates the effect of domestic and global uncertainty on the volatility of the Mexican peso US dollar exchange rate during the period January 1999 - July 2018. The analysis is performed in two stages. In the first stage, we derive an exchange rate volatility measure by estimating a univariate GARCH(1,1) model. In the second stage, we regress the estimated exchange rate volatility on domestic and global uncertainty proxies, built with data from the survey of professional forecasters conducted monthly by Banco de Mexico since 1999. In order to capture the expectations of a broad set of economic agents, we also include as regressors both the Chicago Board Options Exchange Volatility Index (VIX) and Baker, Bloom and Davis global economic policy uncertainty index (EPU). A trade uncertainty index based on Google trends is incorporated in the model to analyze if uncertainty regarding NAFTA and Mexico’s trade liberalization policies has had an impact on the exchange rate volatility. The price of a barrel of Mexican oil mix is also included since the price volatility of this commodity has been shown to affect the peso US dollar exchange rate volatility. In order to control for the surprise component of macroeconomic data announcements the analysis controls for an inflation surprise and a GDP surprise. Finally, we assess whether the effect of domestic political uncertainty and domestic economic uncertainty on exchange rate volatility is amplified in election and recession periods. The main results show that the domestic political uncertainty measure, the VIX and the global EPU indices are the main drivers of the exchange rate volatility. We also find that in recession periods, higher domestic economic uncertainty is associated with higher exchange rate volatility. These findings are robust to alternative exchange rate volatility proxies and econometric techniques.