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Endogenous and Exogenous Volatility in the Foreign Exchange Market

Author

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  • Leonardo Bargigli
  • Giulio Cifarelli

Abstract

We identify two sources of heteroskedasticity in high-frequency financial data. The first source is the endogenous changing participation of heterogeneous speculators to the market, coupled with the time varying behavior of the market maker. The second source is the exogenous flow of market relevant information. We model the first one by means of a Markov switching (MS) SVAR process, and the second one by means of a GARCH process for the MS-SVAR structural errors. Using transaction data of the EUR/USD market in 2016, we detect three regimes characterized by different levels of endogenous volatility. The impact of structural shocks on the market depends on both sources, but the exogenous information is channeled to the market mostly through price. This suggests that the market maker is better informed than the speculators, who act as momentum traders. The latter are able to profit from trade because, unlike noise traders, they respond immediately to price shocks.

Suggested Citation

  • Leonardo Bargigli & Giulio Cifarelli, 2020. "Endogenous and Exogenous Volatility in the Foreign Exchange Market," Working Papers - Economics wp2020_17.rdf, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    • Handle: RePEc:frz:wpaper:wp2020_17.rdf
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    More about this item

    Keywords

    heteroskedasticity; asset pricing model; heterogeneous beliefs; market making; foreign exchange market; Markov switching; GARCH; SVAR; high frequency data.;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C55 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Large Data Sets: Modeling and Analysis

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