CURRENCY CLUSTER AND VOLATILITY CO-MOVEMENT: THE ROLE OF COMMON GLOBAL FACTORS

We investigate the role of common global factors in driving exchange rate behavior, with a particular focus on volatility and volatility co-movement. Utilizing the multivariate factor stochastic volatility (MFSV) model, we identify that exchange rate volatilities are best explained by a three-factor model. A clustering analysis based on factor loadings reveals three distinct currency clusters associated with the USD, EUR and commodity-exporting countries. These clusters are characterized by the different relative importance of the three underlying factors as drivers of exchange rate volatility, which appear to correspond to U.S. monetary policy, European monetary policy and commodity market shocks. Furthermore, we employ wavelet and partial wavelet coherence techniques to analyze exchange rate co-movement and evaluate the significance of common factors as drivers of volatility co-movement. This research offers valuable insights into the mechanisms driving exchange rate volatility and co-movement, highlighting the role of global factors in shaping currency dynamics.