The dynamics of exchange rate volatility: A multivariate latent factor ARCH model

Abstract

Abstract We study temporal volatility patterns in seven nominal dollar spot exchange rates, all of which display strong evidence of autoregressive conditional heteroskedasticity (ARCH). We first formulate and estimate univariate models, the results of which are subsequently used to guide specification of a multivariate model. The key element of our multivariate approach is exploitation of factor structure, which facilitates tractable estimation via a substantial reduction in the number of parameters to be estimated. Such a latent‐variable model is shown to provide a good description of multivariate exchange rate movements: the ARCH effects capture volatility clustering, and the factor structure captures commonality in volatility movements across exchange rates.