The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea

Transcription

1 Macroeconomy and Financial Markets The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea Seungho Lee, Research Fellow* Moderate exchange rate volatility may contribute to FX market development by increasing trading volume, while a radical change in the exchange rate shrinks the market as was seen during the global financial crisis. After the financial crisis, the positive effect of exchange rate volatility that increased the trading volume for Korean won was weakened. This implies that the FX market development may require efforts to prevent excessive exchange rate volatility by strengthening macro-prudentiality in external sector as well as ameliorating FX market infrastructure. Nonetheless, the authorities efforts to stabilize the FX market should be careful not to constrict the market mechanism in a sense that moderate exchange rate volatility can activate market trading and enhance the resilience from external shocks. I. Background During , the volatility of the won/dollar exchange rate was relatively stable and moderate. In the wake of the global financial crisis in 2008, however, the volatility for the Korean won radically increased and the FX trading volume shrank substantially until the financial crisis withered around the second half of Moderate exchange rate volatility in general contributes to an increase in the trading volume in the FX market by attracting arbitrage transactions. However, a radical change in exchange rate shrinks market trading because market participants * All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as the Korea Capital Market Institute s official position. Tel: Tel: , sgholee@kcmi.re.kr 47

2 Capital Market PERSPECTIVE may turn to more conservative for passive risk managements rather than pursue active tradings for arbitrage gains. The relationship between exchange rate volatility and FX trading volume may rely on the internal and external environments surrounding the FX market. An analysis on the relationship between the two elements may provide useful information to investigate the trading behavior of the market participants and to evaluate market sentiments. For that end, this paper analyzes the relationship between the exchange rate volatility and FX trading volume in Korea before and after global financial crisis. II. Current Status of Volatility for Won and Trading Volume 1. Trends of volatility and trading volume Since early 2000, the daily exchange rate volatility for Korean won was mostly stable until 2008 when it increased sharply because of the heightened uncertainty during the global financial crisis. Since the second quarter of 2009, however, volatility reduced gradually as the global and domestic financial market was pacified. During , the exchange rate volatility stood at a relatively stable range, recording on average 0.42% in intraday rate of change and 0.29% in day-on-day rate of change. The implied volatility from the currency option market also declined steadily, showing 6.18% during the same period. Amid a global financial crisis during , however, volatility soared as a result of the increase in risk averseness across international financial markets and massive capital outflows in the process of deleveraging of financial institutions of advanced economies. In particular, during the fourth quarter of 2008 after Lehman s failure, the intraday and day-on-day rate of change for the Korean won recorded its highest at 3.32% and 2.18%, respectively Vol. 4, No. 1

3 The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea Since the second quarter of 2009, volatility started to decline as the financial market became calm. Nonetheless, the level of daily exchange rate volatility in 2011 was a bit higher than that before the global financial crisis, showing 0.64% in intraday rate of change and 0.51% in day-on-day rate of change. Table 1. Daily won/dollar exchange rate volatility (Unit: Period averages, %) /4 Intraday rate of change 1) Day-on-day rate of change 2) Implied Volatility 3) Note: 1) (intraday highest rate - intraday lowest rate)/intraday average rate 100 2) (closing rate for day - closing rate for previous day)/closing rate for previous day 100 3) Based on at the money in 1 month straddle Sources: The Bank of Korea, Bloomberg Figure 1. Rate of change in won/dollar exchange rate Source: The Bank of Korea 49

4 Capital Market PERSPECTIVE Figure 2. Implied volatility in won/dollar exchange rate Source: Bloomberg Meanwhile, the FX trading volume for Korean won seemed affected by the exchange rate volatility. During , the trading volume increased persistently supported by the stable exchange rate volatility. For example, the trading volume in the interbank market increased 34.0% in spot transactions and 79.9% in forward and FX swap transactions on yearly average. However, during the trading volume shrank substantially with the sharp increase in the exchange rate volatility. The spot transactions decreased by 5.3% and 25.4% in 2008 and 2009, respectively. The forward and FX swap also declined 19.0% in the fourth quarter of 2008 and continued to be stagnant in Since 2010, however, the spot transactions in the interbank market resumed to increase and reached US$ 9.1 billion daily average in 2011, surpassing the level before the financial crisis. Forward and FX swaps showed a slight increase than before Vol. 4, No. 1

5 The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea Table 2. Interbank trading volume (Unit: Daily averages, in hundred million dollars, %) / Spots (49.4) (16.1) (40.6) (29.7) (-5.3) (-58.3) (-25.4) (31.4) (18.3) Forwards and FX Swaps (51.4) (97.4) (33.1) (137.8) (7.1) (-19.0) (1.7) (-5.4) (3.6) Total (50.0) (42.1) (37.3) (76.3) (1.9) (-33.4) (-8.8) (6.3) (9.4) Notes: 1) Transactions through FX brokers only. 2) Figures in ( ) represent percentage changes compared with the previous quarters. Sources: The Bank of Korea Figure 3. Trading volume by type Sources: The Bank of Korea In sum, FX trading volume in the interbank market for Korean won persistently increased supported by moderate exchange rate volatility before the global financial crisis. During , however, the spot and FX swap transactions declined sharply because of the heightened risk averseness and uncertainties in the market. Since the second half of 2009, the trend was reversed again with the stabilized exchange rate volatility. 51

6 Capital Market PERSPECTIVE Figure 4. Yearly changes in volatility and trading volume Notes: Transactions in the Korean interbank market. FX turnover includes spots, forwards, and FX Swaps. Sources: The Bank of Korea 2. Comparison by country Compared with 19 emerging countries listed in Table 3, the exchange rate volatility for Korean won appears to be relatively high. Day-on-day rate of change in 2010 is similar to those in Brazil and South Africa, but lower than East European countries such as Czech Republic, Hungary, and Poland. It s worth mentioning that the trading volume of Korea is relatively high among highly volatile countries. The daily trading volume for Korea stands next to Singapore, recording US$ 43.8 billion on daily average in This implies that in spite of the Vol. 4, No. 1

7 The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea exchange rate volatility the FX market has developed in quantity with active trading for the purpose of hedging or arbitrage transactions. Table 3. Volatility and trading volume of emerging countries (2010) Country Exchange Rate Volatility 1) (A) FX Turnover 2) (B) (Unit: In billion dollars, %) (B/A) Brazil Chile China Chinese Taipei Colombia Czech Republic Hungary India Indonesia Korea Malaysia Mexico Philippines Poland Russia Singapore South Africa Thailand Turkey Notes: 1) Period averages of (closing rate for day closing rate for previous day)/closing rate for previous day 100 2) Including interbank and customer transactions Sources: BIS (2010), Bloomberg 53

8 Capital Market PERSPECTIVE Figure 5. Volatility and trading volume of emerging countries (2010) Note: Day-on-day rate of exchange rate changes Sources: BIS (2010), Bloomberg III. Analysis on the Relationship between Volatility and Trading Volume 1. Theoretical background In theoretical studies on the relationship between exchange rate volatility and FX trading volume, the sequential information model (SIM) and the mixture of distribution hypothesis (MDH) are most commonly cited. SIM proposes that new information arriving to a small number of people sequentially spreads to others and thereby volatility and trading volume are affected. Under MDH, it is assumed that new information in the FX market is instantly reflected in the price (exchange rate volatility) and trading volume at the same time Vol. 4, No. 1

9 The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea These models basically assume that the volatility and trading volume have a positive relationship. However, the concrete transmission mechanism between the two, i.e., impact of volatility on trading volume and vice versa, relies on the trading pattern of the market participants and the characteristics of the new information. Meanwhile, inventory control theory implies that the increase in exchange rate volatility or the risks bring about the hot potato trading to square the FX position of the banks, contributing to an increase in the trading volume. In particular, the existence of the asymmetric information may easily cause a speculative transaction and thus enlarge exchange rate volatility. Furthermore, under the efficient market hypothesis the increase in FX trading in an efficient market reduces the arbitrage opportunity and thus diminishes volatility. On the whole, these literature reviews about the relationship between exchange rate volatility and trading volume may be affected by the market condition, shown in the Figure 6 below. When the FX market remains calm and stable, the increase in volatility usually results in expansion of trading volume through the arbitrage transaction and hot potato trading, while the increase in trading in an efficient market condition reduces the volatility with the disappearance of arbitrage opportunity. On the contrary, when the market is unstable and risk aversion is high the increase in excessive volatility in a short period time shrinks FX trading because of increased conservative behavior of the traders. Furthermore, when the increase in trading results from speculation or one-sided expectations, the exchange rate can be more volatile. Figure 6. Relationship between volatility and trading volume by market condition <In case of stable markets> <In case of unstable markets> 55

10 Capital Market PERSPECTIVE A few researches were made on the bilateral relationship in case of Korean won. Chung and Ju (2003) conclude that the won/dollar exchange rate volatility and spot trading volume have positive relations, using daily data during January 2001 and April Lee and Chung (2006) investigate the simultaneous relations between volatility, bid-ask spreads, and trading volume. They conclude that the increase in volatility brings about more active trading in the FX market, while the increase in trading volume reduces the volatility. 2. Relationship between volatility and trading volume The charts in Figure 7 illustrate exchange rate volatility in the horizontal axis and trading volume in the vertical axis using quarterly data. Intraday rate of change and day-on-day rate of change are used for measuring volatility, while the trading volume is classified into spot transaction and total traditional trading, i.e., spot plus forward and FX swap. Excluding the period of the global financial crisis, there seems to be positive relations between the two components. This resulted from the fact that when the market is stable the increase in the moderate exchange rate volatility contributes to increase the trading volume in Korea. However, during the global financial crisis in the fourth quarter of 2008 and first quarter of 2009, exchange rate volatility and trading volume show a negative relation as volatility soared but trading shrank sharply Vol. 4, No. 1

11 The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea Figure 7. Quarterly volatility and trading volume Note: Based on interbank trading, Total FX turnover includes spot, forward and FX swap Source: The Bank of Korea 3. Causality test and impulse response The Granger causality test 1) was implemented to investigate the causality between exchange rate volatility and trading volume before and after the period of global financial turmoil. The empirical results show that uni-directional impacts exist in Korea from volatility to trading volume in both periods. That is, the increase in exchange rate volatility affects the spot trading volume in a systemic way. 1) Daily data are used. The period when the global financial crisis is at the peak is excluded from the empirical test. 57

12 Capital Market PERSPECTIVE Table 4. Granger causality test (period I) Null hypothesis lags (day) Day-on-day rate of change Spots 9.57 ** 9.59 ** 7.00 ** 6.07 ** 4.98 ** Spots Day-on-day rate of change Intraday rate of change Spots ** ** 7.36 ** 5.59 ** 4.41 ** Spots Intraday rate of change 9.03 ** Note : 1) Figures indicate F-value. ** and * means 1%, 5% statistical significance level 2) Period I : January 2004 ~ August 2008 Table 5. Granger causality test (period II) Null hypothesis lags (day) Day-on-day rate of change Spots * 4.07 ** 4.65 ** 4.05 ** Spots Day-on-day rate of change Intraday rate of change Spots ** 7.06 ** 3.58 * 3.66 ** 2.93 * Spots Intraday rate of change Note : 1) Figures indicate F-value. ** and * means 1%, 5% statistical significance level 2) Period II : May 2009 ~ December 2011 The impulse response of the exchange rate volatility to trading volume also indicates that the increase in the volatility positively affects the trading volume in both periods. However, the impact in sample period I (before the crisis) is longer-lasting than in sample period II (after the crisis). This implies that modest exchange rate volatility in period I has a more positive effect to trigger active trading in FX market with dealers elevated trading incentives for arbitrage gains or hot potato trading. Meanwhile, the response of the volatility to trading volume seems to last only two or three days in sample period II, which is much shorter than in sample period I. This is mainly attributable to the fact that recently heightened risk averseness in the global financial market partly due to the fact that on-going Eurozone crisis shrinks FX trading and makes dealers behavior more conservative Vol. 4, No. 1

13 The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea Figure 8. Impulse response of volatility to spot transaction Intraday rate of change (period I) (period II) Day-on-day rate of change (period I) (period II) IV. Summary and Implication The increase in the volatility of the won/dollar exchange rate proved to increase the trading volume, contributing to the development of the FX market. However, it is worth mentioning that excessive volatility particularly during the global financial crisis shrank FX trading sharply because of the heightened risk aversion in the market. In the aftermath of the financial turmoil, FX trading in Korea resumed to gradually increase with stabilizing exchange rate volatility, even though the positive effect of the exchange rate volatility to increase the trading volume seems relatively weaker than before. 59

14 Capital Market PERSPECTIVE This implies that the FX market development may require efforts to prevent excessive exchange rate volatility by strengthening macro-prudentiality in the external sector as well as ameliorating the FX market infrastructure in the long-term. In particular, onesided expectation on the exchange rate or herding behavior should be minimized by attracting more market participants and developing market makers. Nonetheless, the authorities efforts to stabilize the FX market should be careful not to constrict the market mechanism in a sense that moderate exchange rate volatility can activate market trading and enhance resilience against external shocks Vol. 4, No. 1

15 The Relationship between Exchange Rate Volatility and FX Trading Volume in Korea Reference Bank of Korea, Quarterly Foreign Exchange Market Trends, Press Releases. BIS, 2010, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in Chung, C.S., Ju, S.Y., 2003, Trading Volumes and Volatilities in KRW/USD FX Market, The Korean Association of Trade and Industry Studies 8-2. Copeland, T.E., 1976, A model of asset trading under the assumption of sequential information arrival, The Journal of Finance 31(4), p Harris, L., 1987, Cross-security tests of the mixture of distribution hypothesis, Journal of Financial and Quantitative Analysis 21, pp Jennings, R.H., Stark, L.T., Felingham, J.C., 1981, An equilibrium model of asset trading with sequential information arrival, Journal of Finance 36, pp Karpoff, J.M., 1987, The relation between price changes and trading volume: A survey, Journal of Financial and Quantitative Analysis 22(1), pp Lee, S.h., Chung, C.S., 2006, Trading Volume, Volatility and Bid-Ask Spreads: Evidence from Foreign Exchange Market in Korea, Korea Institute of Finance, Journal of Money and Finance, Lyons, R., 1988, Tests of the foreign exchange risk premium using the expected second moments implied by option pricing, Journal of International Money and Finance 7(1). Malliaris, A.G., Urrutis, J.L., 1998, Volume and price relationships: hypotheses and testing for agricultural futures, Journal of Futures Markets 18(1), pp Tauchen, G., Pitts, M., 1983, The price-variability volume relationship on speculative markets, Econometrica 51, pp Torben G. Andersen, T.G., Bollerslev, T., Diebold, F., Labys, P., 2003, Modeling and forecasting realized volatility, Econometrica 71. pp