European Currency Co-Movements and Contagion : Evidence from a Bayesian TVP-(Pseudo)FAVAR Model

In this study we examine the role of the Euro on currency co-movements and contagion considering six major currencies (i.e., EUR(DM), JPY, GBP, CHF, AUD, as well as, CAD) and their corresponding USD exchange rates. The period of study extends from January 2, 1975 to April 8, 2016. The selected period allows us to further identify five distinct intervals, all of which can be regarded as milestones for international economic developments. First, we model conditional volatility, where we introduce a new DCC-GARCH-Copula model with mixed underlying univariate GARCH processes to account for the different characteristics of exchange rate returns. In turn, conditional variances are further integrated into a Bayesian TVP-(pseudo)FAVAR model whereupon, conditional volatility connectedness across currencies is also investigated. Main findings show that conditional correlations decline during the more flexible exchange rates regimes. In addition, contagion in the European market appears to be more pronounced given that both the conditional and the unconditional correlations between the Euro, the GBP and the CHF are relatively high within every considered regime. What is more, volatility connectedness is rather strong throughout the period of study; however, the relative strength of the EUR(DM) rather depends on the respective interval. Apparently, during the Great Recession the Euro becomes weaker. Results remain robust to a series of tests