Volatility (Dis)Connect in International Markets

Lack of comovement between consumption differentials and real exchange rates is a traditional indicator of a disconnect of foreign exchange markets from economic fundamentals. We present novel empirical evidence for the disconnect between the volatilities, as opposed to the levels, of these variables. The volatility correlations are below one, but they are larger than the level correlations. We discuss the economics of volatility disconnect anomaly in settings with complete and incomplete markets and provide an explanation of our empirical findings based on international risk sharing of expected growth and volatility news shocks. This paper was accepted by Tomasz Piskorski, finance. Funding: Y. Liu was supported by the NSFC Excellent Young Scientists Fund [Grant 72422011]. Supplemental Material: The online appendices and data files are available at https://doi.org/10.1287/mnsc.2023.03930 .