Return-Implied Volatility Dynamics of High and Low Yielding Currencies

Abstract

This study investigates the return-implied volatility dynamics of six most actively traded currencies before and during the financial crisis using quantile regression analysis. In particular, we examine how the size and sign of high and low yielding currency futures returns influence implied volatilities in the currency market. It is found that, especially during a volatile period, the behavior of the return-implied volatility relationship of high yielding currencies, such as the Australian dollar, Canadian dollar, and British pound, has some similarities with that in the stock markets, while low yielding currencies behave the opposite way. Investment currencies generally exhibit a negative asymmetry, while funding currencies, the Japanese yen in particular, exhibit a positive asymmetry. The results of the study appear consistent with the recent carry trade literature implying that carry trades, investors' behavior, risk exposure, and global risk explain return-implied volatility dynamics in the currency markets.