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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page What Drives Volatility Persistence in the Foreign Exchange Market?
David Berger, Alain Chaboud, Erik Hjalmarsson, and Edward Howorka
2006-862  (May 2006)

Abstract:  We analyze the factors driving the widely-noted persistence in asset return volatility using a unique dataset on global euro-dollar exchange rate trading. We propose a new simple empirical specification of volatility, based on the Kyle-model, which links volatility to the information flow, measured as the order flow in the market, and the price sensitivity to that information. Through the use of high-frequency data, we are able to estimate the time-varying market sensitivity to information, and movements in volatility can therefore be directly related to movements in two observable variables, the order flow and the market sensitivity. The empirical results are very strong and show that the model is able to explain almost all of the long-run variation in volatility. Our results also show that the variation over time of the market's sensitivity to information plays at least as important a role in explaining the persistence of volatility as does the rate of information arrival itself. The econometric analysis is conducted using novel estimation techniques which explicitly take into account the persistent nature of the variables and allow us to properly test for long-run relationships in the data.

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Volatility persistence, news sensitivity, exchange rates, long memory, fractional cointegration, narrow band spectral regression

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Last update: May 31, 2006