Cross-Dynamics of Exchange Rate Expectations : A Wavelet Analysis

This paper focuses on the cross-dynamics of exchange rate expectations over different time-scales. We use over-the-counter currency options on the euro, Japanese yen, and British pound vis-à-vis the U.S. dollar to extract expected probability density functions of future exchange rates, and apply recent wavelet cross-correlation techniques to analyze linkages in these option-implied exchange rate expectations. The results show that market expectations are closely linked among the three major exchange rates. Regardless of time-scales, we find significant lead-lag relationships between the expected exchange rate probability densities. Nevertheless, our findings also indicate that the dynamic structure of exchange rate expectations may vary over different time-scales. In terms of short-run linkages in volatility expectations, the Japanese yen seems to have a leading role among the exchange rate triplet. At the longer scale, however, we also find significant feedback effects from the GBP/USD volatility expectations to the JPY/USD implied volatilities. The wavelet cross-correlations between the higher-order moments of option-implied exchange rate distributions indicate that the expectations about the JPY/USD rate are virtually unrelated to the developments of the European currencies, while the higher-order moments of the EUR/USD and GBP/USD densities appear strongly linked with each other