Liquidity returns, global risk, and exchange rates: An explanation based on scapegoat theory

Although recent studies show that liquidity return and VIX changes (a global risk measure) have strong connections with exchange rate movements, I show that the relationship between exchange rates and these variables is unstable even after controlling for other fundamentals. I then examine whether this instability can be explained by the scapegoat theory – an explanation that investors over-weight a conspicuous observable variable (the scapegoat variable) to explain currency movements caused by shocks to unobservables. I find (1) that time-varying regressions provide a significantly better fit with exchange rate data, (2) that liquidity return and VIX changes exhibit characteristics of a scapegoat variable in some advanced and emerging economies, and (3) that the scapegoat effect remains relevant for one-year exchange rate returns, though it is present in fewer economies than for three-month currency changes. These pieces of evidence support the validity of the scapegoat theory for exchange rate movements in certain economies.