Volatility Transmission in Exchange Rates During the Asian Crisis






Min Hwang

Department of Economics

University of California, Berkeley




Yung Y. Yang

Department of Economics

California State University, Sacramento


May 1999








Abstract: This paper will investigate the linkage of the volatility of exchange rates of currencies which were adversely affected in Korea and Southeastern Asian countries during the recent Asian financial crisis. Specifically, the paper will examine first how volatility of each country’s currency is affected by other countries’ currencies. Secondly, we will compare the temporal behavior of volatility transmission for pre-crisis and post-crisis periods. In doing this, we will conduct parameter stability test, as well as testing for constancy of conditional correlation coefficients. Third and finally, we will also examine impulse response of volatility during pre- and post- crisis, which will show persistence of the effect of other currencies on the volatility of domestic currency. In carrying this proposed study, we will use the high-frequency exchange rate data from Dow Jones Telerate of Reuters FXFX.



JEL Classification Numbers: F31, F36, F37

Principal author’s E-mail: min@econ.ucberkeley.edu Telephone Number: 510) 642-3048




Volatility Transmission in Exchange Rates during the Asian Crisis



1. Introduction

When Thailand decided to float its baht, not many observers foresaw the real magnitude of the impending crises that later battered several Asian and Latin American countries; ironically most of these countries had been believed to be successful models of economic growth. The float of the Thai baht initially triggered depreciation of nearby countries’ currencies, including the Malaysian ringgit, the Indonesian rupiah, and the Philippine peso. At that time, depreciation of Southeastern Asian countries currencies was viewed, at best, as "correction" of overvalued currencies, and was believed to help to manage external balances. It was in late October 1997 that revealed the true nature of crises when Taiwan abandoned intervention on behalf of the New Taiwan dollar, which triggered speculative attacks on the Hong Kong dollar, the Korean won and some of Latin American currencies, especially the Brazilian real and the Argentine peso. These speculative attacks intensified in December 1997 when it became known that Korea’s reserves were almost depleted. By following January, the Indonesian rupiah lost 81 percent of its value relative to its July 1, 1997 level. Similarly, the Thai baht, the Malaysian ringgit, and the Philippine peso all lost their values by 56 percent, 46 percent, and 41 percent, respectively. During the short interval from October 1 to late December 1997, the Korean won lost its value by 55 percent. While these episodes of rapid depreciation of these currencies that were severely affected are well known, it needs to be pointed out that the volatility of these affected currencies also sharply increased to unprecedented levels during the crises and, more notably, the increase in volatility occurred almost simultaneously with the affected currencies.

This paper will investigate the linkage of the volatility of exchange rates of affected countries during the crisis. There can be many reasons why volatility of exchange rates is linked each other. One reason is that fundamentals of exchange rates, especially trade and investment, are related, and therefore any new information about fundamentals might affect the volatility of corresponding countries at the same time. Since foreign exchange markets are almost perfectly integrated on a 24-hour trading basis, a change in volatility of one currency due to the new information about fundamentals should be transmitted to the other currency’s volatility simultaneously. Most explanations that emphasize the importance of macroeconomic fundamentals view a contagious nature of currency crises in similar ways. However, the magnitudes of crises have often been observed to be too large to be explained by fundamentals only (Sachs, Tornell and Velasco 1996). The other reason for linkage between volatility of exchange rates is "market psychology." Even if there were no apparent common fundamentals between currencies, but speculations based on fads, noises or herd instinct might be transmitted. If, during the crises, foreign exchange traders are unable to identify the source of shocks, especially between global shocks and local shocks, trying to infer the source of shocks from observing exchange rates could lead to correlation between exchange rate volatility and transmission of idiosyncratic errors to the other exchange rates (King and Wadhwani 1990). Also, it has been pointed out that mere existence of currency crises in other countries increase the probability of attacks on domestic currency even after taking fundamentals into consideration (Eichengreen, Rose and Wyplosz 1996).

Hypothesis and Model

The model we will estimate is based on Engle, Ito and Lin (1990) and Kroner and Ng (1995). where is an exchange rate of country i at time t+1 and is an error term at t+1 and assumed to follow conditional hetersckedastistic process with being conditional variance of . Then we have


is i.i.d with

. (1)


Specifically, this paper will address the following questions. First, how volatility of each country’s currency is affected by other countries’ currencies? Because the implications on exchange rate volatility arising from common fundamentals as opposed to from market psychology, we can test these two views directly by examining the effect of past volatility of foreign countries’ on current volatility of the domestic country, i.e., . One problem that might arise is that even if volatility seems to transmit from one country to another, it might not mean that the volatility is due to the market psychology because two countries might have very similar fundamental problems. We will overcome this problem by the use of high frequency data. Second, we can compare the temporal behavior of volatility transmission for pre-crisis and post-crisis periods. If temporal behavior of volatility transmission (and ) is systemically different, then support for the fundamentalist’s view might be weakened. In addition to parameter stability test, we can also test for constancy of conditional correlation coefficients. Third, we can also examine impulse response of volatility during pre- and post- crises, which will show persistence of the effect of other currencies’ on the volatility of domestic currency. If fundamentalist view is correct, then the effect of previous domestic volatility should be greater. .


We will use the high-frequency exchange rate data, which has been rarely used in the analysis of currency crises. Indicative quotes of one-minute intervals are collected from Dow Jones Telerate. Indicative quotations are not transaction price, rather an advertised price from foreign exchange dealers to customers. Actual transaction data is very rare in academic research and most of high frequency foreign exchange analysis is based on indicative quotes from Dow Jones Telerate of Reuters FXFX. Since indicative quotes are not "firm," there has been some question for validity of using the series in the place of transaction price. Goodhart, Ito and Payne (1996) compare the difference between indicative quotes (from FXFX) and firm quotes (from D2000-2) and find little difference between two in GARCH estimation. While the data may not ideal for our purpose; but since we are mainly interested in the volatility transmission process between currencies, the current data set should be appropriate if care is taken when we interpret the estimation results. We will compare Korean won, Malaysian ringgit, Indonesian rupiah, Philippine peso, Hong Kong dollar, Taiwan dollar and Thai baht. In addition we will add Japanese yen for benchmark currency for Asian countries. All currencies are based on US dollar.


Eichengreen, Barry, Andrew Rose and Charles Wyplosz, 1996, Contagious Currency Crises: First Tests, Scandinavian Journal of Economics 98, 463-484.

Engle, Robert F., Wen-Ling Lin, and Takatoshi Ito, 1990, Meteor Showers or Heat Waves? Hetroskedastic Intra-daily Volatility in the Foreign Exchange market, Econometrica 58, 525-542.

Goodhart, Charles and Takatoshi Ito and Richard Payne, 1996, A Study of the Reuters D2000-2 Dealing System, In The Market Microstructure of Foreign Exchange Markets, ed. Jeffrey Frankel, Giampaolo Galli and Alberto Giovannini. Chicago: University of Chicago Press.

King, Mervyn and Sushi Wadhwani, 1990, Transimission of Volatility between Stock Markets, The Review of Financial Studies 3, 5-33.

Kroner, Kenneth and Victor Ng, 1995, Modeling the Time Varying Comovement of Asset Returns, manuscript.

Lin, Wen-Ling , Robert F. Engle, and Takatoshi Ito, 1992, Do Bulls and Bears Move Across Borders? International Transmission of Stock Returns and Volatility as the World Turns, working paper, UCSD.

Los, Carlos, Nonparametric Testing of the High-Frequency Efficiency of the 1997 Asian Foreign Exchange Markets, working paper no. 98-03, Center for Research in Financial Services.

Sachs, Jeffrey, Aaron Tornell and Andres Velaso, 1996, Financial Crises in Emerging Markets : The Lessons from 1995, Brookings Papers on Economic Activity, no.1, 147-215.

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