Effect of exchange rate return on volatility spill-over across trading regions Don U.A. Galagedera a, *, Yoshihiro Kitamura b a Department of Econometrics and Business Statistics, Monash University, 900 Dandenong Road, Caulfield East, Victoria 3145, Australia b Faculty of Social Sciences, Waseda University, 1-6-1 Nishi-waseda Shinjuku-ku, Tokyo 169-8050, Japan 1. Introduction In times of financial crises which have adverse impacts on global economies, investors usually tend to stay away from highly volatile stock markets, and may escape into less risky markets in relatively secure countries. For investors, one alternative would then be to look for ‘safe-haven’ currencies in the foreign exchange markets. The US dollar has been the dominant ‘safe-haven’ currency for a very long time. However, the recent emergence of the euro, the Swiss franc and the Japanese yen as potential ‘safe- haven’ currencies has reduced the domination of the US dollar. Hence, it seems reasonable that one currency may be attractive as a ‘safe-haven’ currency during certain time periods and not in others. In any case, in times of crisis, investors will be looking for low risk currencies. This was evident during the subprime crisis that originated in the US. During the subprime crisis period, the yen appreciated against the US dollar, suggesting that the yen may be an alternative ‘safe-haven’ currency relative to the US dollar. A pertinent question here is how to test such a postulation econometrically. In this study we develop an econometric model for testing whether or not the yen served as a ‘safe-haven’ currency relative to the US dollar during the subprime crisis period. This is done by modelling the effect of the realized US dollar–yen exchange rate returns on the US dollar–yen exchange rate return volatility spill-over across different trading zones. Previous studies of the volatility spill-over in foreign exchange markets may be classified into two broad categories: those that investigate it across different foreign exchange markets and those that investigate it across different geographical trading zones. A model for investigating the volatility spill-over across foreign exchange market sis proposed by Engle et al. (1990). Engle et al. formulate a model for examining the US dollar–yen exchange rate volatility linkages across different markets, so that the source of volatility may be identified. They investigate two hypotheses of information linkage across foreign exchange markets: heat waves and meteor showers. The heat-wave hypothesis stipulates that the volatility of the exchange rate returns in a given market is influenced by the past volatility of the exchange rate returns in the same market; while the meteor-shower hypothesis assumes the volatility of the exchange rate returns in a given market to be influenced by the spill-over of volatility from the other markets. Engle et al. (1990) test these two hypotheses in the New York and Tokyo foreign exchange markets, and report evidence suggesting the presence of volatility clustering of the meteor-shower type. Melvin and Melvin (2003) highlight the fact that investigating the volatility transmission using daily opening and closing prices for the Tokyo and New York foreign exchange markets, as Engle et al. (1990) did, is problematic, because one morning and one afternoon observation may not really reflect the trading activity in major foreign exchange trading centres. For high frequency data, Dacorogna et al. (1993) and Andersen and Bollerslev (1997) Japan and the World Economy 24 (2012) 254–265 A R T I C L E I N F O Article history: Received 2 December 2010 Received in revised form 5 February 2012 Accepted 24 July 2012 Available online 1 August 2012 JEL classification: F31 G15 Keywords: Exchange rate Volatility spill-over High-frequency data A B S T R A C T This paper examines the effect of realized exchange rate returns on the volatility spill-over between the euro–US dollar and US dollar–yen currency pairs across the five trading regions: Asia, Asia–Europe overlap, Europe, Europe–America overlap and America. Modelling the interaction between returns and volatility in an autoregressive five-equation system, we find evidence that depreciation of the US dollar against the yen has a greater impact on the US dollar–yen volatility spill-over than appreciation in the subprime crisis period. Appreciation and depreciation of the US dollar against the euro does not appear to have an asymmetric effect on the euro–US dollar volatility spill-over. Our results support the notion that the yen may have been preferred to the euro as a ‘safe-haven’ currency relative to the US dollar during the subprime crisis period. ß 2012 Elsevier B.V. All rights reserved. * Corresponding author. E-mail addresses: Tissa.Galagedera@buseco.monash.edu.au (Don U.A. Galagedera), kitamura@waseda.jp (Y. Kitamura). Contents lists available at SciVerse ScienceDirect Japan and the World Economy jo ur n al h o mep ag e: www .elsevier .c om /loc ate/jw e 0922-1425/$ – see front matter ß 2012 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.japwor.2012.07.003