The Quarterly Review of Economics and Finance 52 (2012) 15–37 Contents lists available at SciVerse ScienceDirect The Quarterly Review of Economics and Finance jo u rn al hom epage: www.elsevier.com/locate/qref Exchange rates and oil prices: A multivariate stochastic volatility analysis Liang Ding a , Minh Vo b,c,∗ a Macalester College, 1600 Grand Avenue, St. Paul, MN 555105, USA b Metropolitan State University, 1501 Hennepin Avenue, Minneapolis, MN 55403, USA c Deakin University, Burwood, VIC 3125, Australia a r t i c l e i n f o Article history: Received 13 October 2010 Received in revised form 24 August 2011 Accepted 22 January 2012 Available online 4 February 2012 Keywords: Oil price risk Exchange rate risk Multivariatestochastic volatility Multivariate GARCH Volatility forecast a b s t r a c t This paper uses the multivariate stochastic volatility (MSV) and the multivariate GARCH (MGARCH) mod- els to investigate the volatility interactions between the oil market and the foreign exchange (FX) market, in an attempt to extract information intertwined in the two for better volatility forecast. Our analysis takes into account structural breaks in the data. We find that when the markets are relatively calm (before the 2008 crisis), both oil and FX markets respond to shocks simultaneously and therefore no interaction is detected in daily data. However, during turbulent time, there is bi-directional volatility interaction between the two. In other words, innovations that hit one market also have some impact on the other at a later date and thus using such a dependence significantly improves the forecasting power of volatility models. The MSV models outperform others in fitting the data and forecasting exchange rate volatility. However, the MGARCH models do better job in forecasting oil volatility. © 2012 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved. 1. Introduction It is well-known that oil prices and the U.S. dollar exchange rates are highly correlated. Given the fact that oil is quoted in U.S. dol- lars, it is natural to hypothesize that exchange rates drive oil prices. More specifically, other things equal, when the U.S. dollar depre- ciates, oil-exporting countries would raise oil prices in order to stabilize the purchasing power of their (U.S. dollar) export revenues in terms of their (predominately) euro-denominated imports. This is equivalent to a reduction in supply or a leftward shift in the sup- ply curve. On the demand side, the U.S. dollar depreciation makes oil less expensive for consumers in other countries (in local cur- rency), thereby increasing their crude oil demand. Both effects, the reduction in supply and the increase in demand, cause an increase in oil prices denominated in U.S. dollars. The exchange-rate-to-oil- price causality relationship is supported by the empirical evidence found in Zhang, Fan, Tsai, and Wei (2008), Krichene (2005), and Yousefi and Wirjanto (2004). From the other perspective, exchange rates are believed to be determined by expected future fundamental conditions, among which oil is surely an important factor. Increasing oil prices lead to stronger economies for oil-exporters and higher production costs for oil-importers, hence it would cause the appreciation of ∗ Corresponding author at: Metropolitan State University, 1501 Hennepin Avenue, Minneapolis, MN 55403, USA. Tel.: +1 612 659 7305; fax: +1 612 659 7268. E-mail address: minh.vo@metrostate.edu (M. Vo). oil-exporter currencies relative to those of oil-importers. So, it is likely that the causality runs from oil prices to the exchange rate. Benassy-Querea, Mignonb, and Penot (2007), Coudert, Mignon, and Penot (2007), Chen and Chen (2007), Ayadi (2005), Chaudhuri and Daniel (1998) and Krugman (1984) all provide evidence supporting this view. These studies, despite their mixed implications, tend to suggest that oil prices and exchange rates probably both contain informa- tion that can affect each other. Accordingly, Chen, Rogoff, and Rossi (2008) and Groen and Pesenti (2010) use exchange rates to obtain a better forecast of oil (and other commodities) prices, while Amano and Norden (1998) improve the exchange rate forecast by including oil price in the model. The current literature that examines the relationship between oil price and exchange rate, as cited above, mainly focuses on their returns. As noted by Clark (1973), Tauchen and Pitts (1983), and Ross (1989), the volatility of an asset is also related to the rate of information flow across interacted markets. So the link between the oil and the FX markets should appear not only in return but also in volatility. Examining the volatility interaction between exchange rates and oil prices can shed light on the direction of the causality relationship from a new perspective. Furthermore, if a significant connection does exist, extracting and using the information inter- twined in both markets would improve forecasts of exchange rate and oil volatilities, which are critical in many areas of modern finance. Instead of focusing on the relationship between exchange rate and oil returns, which many papers cited above have investigated, 1062-9769/$ – see front matter © 2012 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved. doi:10.1016/j.qref.2012.01.003