A Multiple-Horizon Search for the Role of Trade and Financial Factors in Bilateral Real Exchange Rate Volatility

Abstract

This working paper was written by Yin-Wong Cheung (University of California, Santa Cruz) and Kon S. Lai (California State University, Los Angeles).

This study investigates the sources of bilateral real exchange rate (RER) volatility in industrial countries. Going beyond traditional macroeconomic determinants, we identify the role of both trade and finance-related factors in explaining RER volatility at different time horizons. The results suggest that RER volatility tends to increase with financial openness and with transport costs but decrease with trade openness and with financial depth. Moreover, the time horizon matters. Financial factors (financial openness and financial depth) are found to influence RER volatility at primarily short horizons, while trade-related factors (trade openness and transport costs) contribute significantly also to RER volatility at much longer horizons. The relative importance of traditional macroeconomic fundamentals and these trade- and finance-related factors can vary considerably across horizons.

Keywords: Exchange Rate Volatility, Time Horizons, Trade Openness, Financial Openness, Financial Depth

JEL Classification: F15, F31, F41