Currency Comovement

In view of the recent emergence of currencies as an independent asset class, it is of considerable importance to examine whether and how currencies comove in foreign exchange markets. In this paper, we (i) document the pattern of currency comovement for a sample of 38 floating-rate currencies, (ii) study its implications for the magnitude of currency risk, and (iii) offer an explanation for the observed comovement pattern. The key findings include: First, the comovement of currencies critically depends on the numeraire against which currency returns are measured: For instance, currency returns are highly correlated when measured against the yen, less so against the euro, and least correlated against the U.S. dollar. Consequently, yen- or euro-based agents face a substantially higher currency risk than dollar-based agents. Second, most of our sample currencies significantly comove with the major currencies, especially the euro and U.S. dollar. The comovements of lesser currencies with the two major currencies significantly drive the overall pattern of currency comovement among our sample currencies. Third, there exists a significant negative relationship between comovements of our sample currencies with the euro vs. the dollar, pointing to a latent competition between the two major currencies on influencing lesser currencies. A currency's relative comovement with the euro vs. the dollar, measured by the currency betas, depends on the relative trade intensity and financial integration of the third country with the euroland vs. the U.S., relative importance of primary commodities in the country's overall exports, severity of inflation, and the country's colonial heritage and geographical location.