Detecting exchange rate contagion using copula functions

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Banco de la Republica de Colombia, Borradores de Economia, No: 1047

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Gómez-González, José Eduardo; Cubillos-Rocha, Juan Sebastian; Melo-Velandia, Luis Fernando
Banco de la República de Colombia
Funciones cópula; Contagio de tasas de cambio; Economias emergentes y desarrolladas; C32 - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models; C51 - Model Construction and Estimation; E42 - Monetary Systems; Standards; Regimes; Government and the Monetary System; Payment Systems; Copula functions; Exchange rate contagion; Emerging and developed economies; Tipos de cambio -- Estudios comparados; Mercados de divisas -- Reino Unido; Mercados de divisas -- Alemania; Mercados de divisas -- Corea del Sur; Mercados de divisas -- Indonesia; Mercados de divisas -- Brasil; Mercados de divisas -- Chile; Modelos econométricos -- Colombia; C32 - Modelos de series temporales; Regresiones cuantiles dinámicas; Modelos dinámicos de tratamiento; procesos de difusión; representación de espacios de estados; C51 - Construcción de modelos y estimación; E42 - Sistemas monetarios; Patrones; Regímenes; Gobierno y sistema monetario; Sistemas de pago; Copula functions; Exchange rate contagion; Emerging and developed economies, Funciones copula; Contagio en tasas de cambio; Economías desarrolladas y emergentes
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paper description
We study exchange rate dependencies between seven countries from four different regions of the world. Our sample includes two developed countries, the United Kingdom and Germany (representing the Euro Area), two large emerging Asian economies, South Korea and Indonesia, two Latin American countries, Brazil and Chile, and South Africa. The currencies of all of these countries are actively traded in global forex markets and all of them are important for large international portfolio composition and rebalancing. We construct multivariate copula functions using a regular vine copula approach, allowing for very flexible dependency structures. We fi nd evidence of exchange rate contagion for our set of countries. However, important asymmetries are worth noting. First, contagion occurs only during periods of exchange rate appreciation of the different currencies with respect to the United States Dollar. We do not fi nd evidence of contagion for any pair of exchange rates during periods of currency depreciations. Second, contagion is more frequent in pairs of countries that include either the United Kingdom or Germany. In fact, the largest tail dependence coefficient corresponds to the pair composed by these two countries' exchange rates. Third, contagion occurs more within countries of a same region, for instance, between Brazil and Chile, and between Korea and Indonesia. This result shows that, in episodes of large currency appreciation, hedging strategies for global investors taking positions in large markets require regional diversi cation.