Time-Varying Comovement of Foreign Exchange Markets

TL;DR

This paper introduces a novel time-varying cointegration model for foreign exchange rates, revealing that market comovement has generally increased over the last 25 years with notable shifts around 1995 and 2008.

Contribution

It proposes a new measure of market comovement based on a time-varying loading matrix in the VEC model, capturing the dynamic strength of long-run relationships.

Findings

Market comovement has increased over 25 years.

The rate of increase slowed around 1995 and 2008.

Market integration dynamics are linked to macroeconomic trends.

Abstract

A time-varying cointegration model for foreign exchange rates is presented. 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 those macroeconomic 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 the rate at which market comovement strengthens is decreasing with two major turning points: one in 1995 and the other one in 2008.