Detecting exchange rate contagion using copula functions

We study exchange rate dependence for seven countries from four different regions of the world. Our sample includes two developed countries, the United Kingdom and Germany (representing the Euro Area), two large emerging Asian economies, South Korea and Indonesia, two Latin American countries, Brazil and Chile, and South Africa. The currencies of all of these countries are actively traded in global forex markets and all of them are important for large international portfolio composition and rebalancing. We construct multivariate copula functions using a regular vine copula approach, allowing for very flexible dependency structures. We find evidence of exchange rate contagion for our set of countries. However, important asymmetries are worth noting. First, contagion occurs only during periods of exchange rate appreciation of the different currencies with respect to the United States Dollar. Second, contagion is more frequent in pairs of countries that include either the United Kingdom or Germany. In fact, the largest tail dependence coefficient corresponds to the pair composed by these two countries’ exchange rates. Third, contagion occurs more within countries of a same region, for instance, between Brazil and Chile, and between Korea and Indonesia. This result shows that during episodes of large currency appreciation hedging strategies for global investors taking positions in large markets requires of regional diversification.