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Strong comovements of exchange rates: Theoretical and empirical cases when currencies become the same asset

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Michael Kühl

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Abstract

The aim of this paper is to detect periods in which two currencies can be classified as being the ”same” asset. Two currencies can be treated as the same asset if their exchange rates vis-`a-vis the same base currency are cointegrated with a cointegration vector that is consistent with the triangular arbitrage condition. In a first step, it is theoretically derived under which conditions, with respect to the process of the fundamentals, the exchange rates are cointegrated. The empirical results yield that periods of strong comovements of the US dollar and Pound sterling based upon the Euro prevail during the 1990s and periods of comovements of Euro and Pound sterling denominated in US dollar prevail since the introduction of the Euro. Furthermore, no long-run relationships can be discovered. This paper gives four major innovations to the literature. It first shows under which conditions exchange rates can be bivariately cointegrated. Secondly, it uses the cross-rate identity to test for cointegration, i.e. deducing recursively. Thirdly, it applies the cointegration methodology within a triangular framework by detecting cointegration between exchange rates that are not only denominated in U.S. dollars. And lastly, it shows that comovements between two exchange rates exist in a narrower sense but only in short periods, whereas the economic variables which have caused the relationship are explored.

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Paper provided by cege – Center for European, Governance and Economic Development Research, University of Goettingen (Germany). in its series cege – Center for European, Governance and Economic Development Research Discussion Papers with number 76.

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Length: 51 pages
Date of creation: 28 Jul 2008
Date of revision: 03 Sep 2008
Handle: RePEc:got:cegedp:76

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Keywords: Foreign Exchange Market; Comovements; Cointegration; Long-Memory;

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Find related papers by JEL classification:
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
F31 - International Economics - - International Finance - - - Foreign Exchange
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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