Decomposing exchange rate volatility around the Pacific Rim

Volatility in exchange rates is decomposed into components associated with domestic and international concerns for six Pacific Rim currencies. A latent factor model is used to model bilateral exchange rate changes as the weighted sum of three factors; two factors are uniquely associated with each of the currencies involved in the exchange rates and the other represents world shocks common to all exchange rates. The results show that international factors are more important in determining exchange rate volatility for the smaller nations of Australia, Singapore, and New Zealand, than for the larger nations of Japan and Canada.