| Abstract |
The foreign exchange market is by far the largest financial market as a single asset market. In this study, we document that the degree of comovement between bilateral USD exchange rates has increased substantially since the introduction of the euro in 1999, and then investigate what has driven such a marked increase in comovement. For each of our 33 sample bilateral USD exchange rates, we measure the degree of comovement using the R-square from regressing weekly exchange rate changes on the weekly world exchange rate factor. Our results show that, for the majority of sample exchange rates, the R-square has increased substantially over the sample period 1999-2010. Specifically, the average R-square was 0.15 in 1999, but it increased to about 0.47 in 2010. Further analyses show that the rising influence of the euro relative to USD over a third currency can explain most of the increased comovement over time. Cross-sectional regression analyses indicate that the cross-sectional variations in trade propensity, financial integration, and inflation have some additional power in explaining the cross-sectional variation in the measured comovement | however, the panel regression analyses reveal that once the effect of the influence of the euro relative to USD over a third currency is controlled for, the other explanatory variables lose most of their power in explaining the time-series variation in the measured comovement. Our results remain robust to various regression model specifications and alternative ways of constructing the world exchange rate factor. |