Information flow and trading volumes in foreign exchange markets: The cases of Japan and Korea

Transcription

1 Informaion flow and rading volumes in foreign exchange markes: The cases of Japan and Korea We invesigae he empirical relaionship beween rading volumes and spo foreign exchange raes of Korean won (KRW/USD) and Japanese yen (JPY/USD) agains he US dollar. We analyze he relaionship using wo differen rading volumes (spo and currency fuures) and realized volailiy measured by high-frequency (wo-minue) daa (Andersen, Bollersleve, Diebold and Labys (2003)). I is found for he KRW/USD and he JPY/USD ha here is a conemporaneous posiive correlaion beween wo rading volumes and volailiies. Such relaion, however, does no appear consisenly when hisorical volailiy is used as proxy for volailiy. Also, empirical resuls sugges ha dynamic relaions beween volumes and volailiy are very differen in boh foreign exchange markes. The difference in boh foreign exchange markes comes eiher (or boh) from under developed hedging markes or from inefficiency in KRW/USD foreign exchange marke. Deparmen of Economics, Sogang Universiy, Seoul, Korea. cschung@sogang.ac.kr. *** Deparmen of Economics, Konkuk Universiy, Seoul, Korea. joosy@konkuk.ac.kr.

2 The foreign exchange marke is he larges and fas-growing financial marke wih daily urnover in he world. The esimaed daily urnover volume in global foreign exchange markes reached $1,500 billion in April 1998, which is more han 100 imes as large as rade flows. Ye, exchange rae models have lile o say abou rading volume, much less he degree o which volume conveys useful informaion. In radiional macro approach, asse prices adjus every period o make agens conen wih he specified amoun of asses in he porfolios. The adjusmen of asse prices insananeously reflecs he arrival of new informaion in he markeplace, which all paricipans observe and inerpre in he same way. Hence, he basic macroeconomic model of he exchange rae implies all informaion peraining o he curren and fuure fundamenal deerminans of exchange raes. In addiion o he lack of economic models, he unavailabiliy of spo volume daa a reasonable high frequencies is a principal handicap for many foreign exchange ime-series analyses. Because of he unavailabiliy of daa, many previous sudies have used foreign currency fuures volume. An obvious drawback in hese sudies is ha rading volume in fuures is very small compared o OTC volume. Also, wo markes are regulaed under differen rading rules. Therefore, he small rading volume size migh be due o eiher he small number of marke paricipans or he differen informaion conens of volume. The posiive relaionship beween spo and fuures volumes may be quie differen in heir overall behavior. Foreign exchange marke urnover growh, for example, slowed down considerably in he lae 1980s, while fuures urnovers coninued o grow vigorously. The oher problem is ha he choice of fuures volume may also induce an omied-variable problem in he esimaion as poined ou by Dumas (1996). Forunaely, boh ypes of rading volume have been observed in he Korean won and he Japanese yen agains US dollar (henceforh KRW/USD and JPY/USD, respecively) exchange marke, which allowed us o deermine he relevancy of inerpreaion of he currency fuures volume. Mos currency spo rading in Korea is done hrough wo foreign exchange brokers and he Korean foreign exchange auhoriy keeps rack of he rading volume. The dollar fuures rading began wih he esablishmen of Korea

3 Fuures Exchange in April 1998, making daa on dollar fuures rading volume available for use. The Korean won, no being an inernaionalized currency, is no raded around he clock, le alone having an offshore marke. Therefore, he repored rading volume can be considered o well represen he acual rading volume. Spo rading volume and KRW/USD are available from he Bank of Korea, and currency fuures volume is available from he Korea Fuures Associaion. The JPY/USD s spo and currency fuures rading volume daa are obained from Daasream. Like brokers in Korea all Japanese foreign exchange brokers should repor heir JPY/USD rading volume concluded beween opening and 3: 30 p.m. (local ime) o he Bank of Japan. Currency fuures volumes come from Chicago Inernaional Moneary Marke as in Glassman (1987) and Bessembinder (1994). The aim of his sudy is o ake he KRW/USD and JPY/USD exchange raes, which are advanageous in erms of daa availabiliy, and compare and analyze wha effec he spo rading volume and currency fuures rading volume have on he volailiy of exchange rae. In realiy, he exising lieraure on rading volume is based on vague belief ha he currency fuures rading volume provides reliable informaion on he spo rading volume. By using boh spo and currency fuures rading volumes, we inend o provide he empirical groundwork o see wheher he currency fuures rading volume can be used as a proxy for spo volume. The empirical invesigaion also provides clues on discerning, so called, beween mixure of disribuion and sequenial arrival informaion hypoheses. Following he work of Clark (1973), he mixure of disribuion hypohesis posis a conemporaneous dependence of volailiy and volume on an underlying laen even or informaion flow variable. The sequenial informaion arrival hypohesis, on he conrary, assumes ha raders receive new informaion in a sequenial and random fashion, which suggess lagged values of volailiy may have he abiliy o predic curren rading volume, and vice versa. Empirical works on conemporaneous correlaion and lead-lag relaion shed ligh on discriminaing beween he wo heoreical explanaions. The oher conribuion o he lieraure is ha we use daily realized volailiy, ermed by Andersen, Bollersleve, Diebold and Labys (2001a, b, 2003), by using high frequency daa on he KRW/USD and JPY/USD exchange raes and analyze wha effec he spo rading volume and currency fuures rading volume have on realized

4 volailiies. Tha is, we rea he exchange rae volailiy as observed raher han laen in empirical works. Realized volailiy separaes iself largely from he volailiy esimaed by exising ime series models, in ha i allows observaion. I is simple o find realized volailiy; for example, daily volailiy can be esimaed by adding he squares of each reurns of minue-uni high frequency daa. Using realized volailiy, we ake boh conemporaneous and dynamic relaionships ino consideraion when analyzing he relaionship beween he spo and currency fuures rading volumes and volailiy. A brief summary of he analysis is as follows. The realized volailiy of he KRW/USD and JPY/USD exchange raes have a posiive relaionship wih boh he spo rading volume and he currency fuures rading volume conemporaneously. The currency fuures rading volume and he realized volailiy of KRW/USD seem o have a feedback relaionship. The resul of our analysis shows ha he effec of a shock from he currency fuures rading volume on he realized volailiy can las more han en days. However, here is no clear dynamic relaionship beween hem for JPY/USD. There is uni-direcional dynamic relaionship from realized volailiy o spo rading volume of JPY/USD. Our empirical resuls are in favor of mixure of disribuion hypohesis in he KRW/USD spo foreign exchange marke and canno give clear answer for model selecion in he JPY/USD spo foreign exchange marke. This sudy is organized in he following manner. The nex secion gives an overview of he exising lieraure on he relaionship beween rading volume and volailiy, as well as on realized volailiy. Secion 3 describes he characerisics of he daa used including hose used o esimae realized volailiy. Secions 4 and 5 analyze he conemporaneous and dynamic effecs of he spo and currency fuures rading on realized volailiy. Secion 6 concludes wih suggesions for fuure research. 2. Lieraure Review A heoreical explanaion of he posiive relaionship beween rading volume and volailiy is ha boh variables are boh driven by he arrival of new informaion as in mixure of disribuion model, which elaboraes on Clark (1983), Epps and Epps (1976), and Tauchen and Pis (1983). In his model he join disribuion of daily price changes and ransacion volume of an asse is derived from a model of inra-day equilibrium

5 price changes and inra-day volume. New informaion during he day causes raders o updae heir reservaion prices and demand or supply of an asse unil he average of heir individual reservaion prices clear he marke again. If hey disagree on he inerpreaion of he new informaion, hen he respecive equilibrium price change comes wih high ransacion volume, while relaive unanimiy resuls in a price change wih lile volume. More formally, marke prices P and volume V are modeled as: P = σ 1 2 I z, V = µ I + σ 1 2 I z 2, where z1 and z 2 are independen N(0,1) variables, and I represens he random number of daily equilibria, on accoun of he new informaion arriving a he marke. The mean µ 2 and he sandard deviaion σ 2 of inra-day volume are boh increasing funcions in rader disagreemen as measured by he sandard deviaion of individual rader's reservaion price updae due o he arrival of new informaion. The empirical analysis of rading volume and volailiy mosly focuses on he sock marke. Sudies on he foreign exchange marke were limied due o he unavailabiliy he spo rading volume, as menioned earlier. Of sudies using he currency fuures rading volume, Baen and Bhar (1993) show ha, by using he Japanese yen, currency fuures rading volume and volailiy have a posiive relaionship in boh he US rading hours and he Asian rading hours. Jorion (1996) finds ha implied volailiy and currency fuures rading volume have a posiive relaionship in erms of he Deusche mark. Charah e al (1996) have applied he GARCH(1,1) model o five currencies raded a he Chicago Board of Trade, he serling pound, Deusche mark, Swiss franc, Canadian dollar, and Japanese yen, and found ha he increase in he rading volume increases he volailiy of he spo exchange rae. Harmann (1998) uses he riennial foreign exchange rading volume repored in BIS survey by combining a large cross-secion of exchange rae wih volume ino a panel. However, he analysis faces he problem of having limied ime series informaion. Harmann (1999) uses a new 8-year long daily volume series for he dollar/yen spo marke analysis. In Japan, all foreign exchange brokers have o repor heir rading

6 volume in yen/dollar o he Bank of Japan. Wei (1994) has also used he same daa source, bu he seleced only one daily observaion per monh o see he relaionship beween volailiy and bid-ask spreads. These daa have also some drawbacks; hey could be affeced by changes in he share of brokered deals in he oal rading. Moreover, he broker volume migh sill be slighly differen from he direc iner-dealer volume: dealers end o urn o brokers for larger ransacions because anonymiy for larger deals is more imporan han for smaller ones. Also, since he yen is an inernaionalized currency raded around 24 hours hroughou he world, he daa represen a very small fracion of he global yen/dollar marke. Lyons (1995) looks a high-frequency daa on acual ransacions in he OTC marke. The ransacion daa including informaion on he direcion of order flows was obained by observing a foreign exchange dealer in New York in one week in A shorcoming of he research is ha i covers only a limied segmen of foreign exchange markes and spans a relaively shor ime period. Galai (2000) uses wha is similar o he daa se of his sudy, daily rading volume for he dollar exchange raes of seven currencies, currencies of Brazil, Colombia, India, Indonesia, Israel, Mexico and Souh Africa, and finds ha in mos cases volume and volailiy are posiively correlaed, which is an indicaion ha hey boh reac o unobserved common facors. However, he invesigaion neiher covers he Korean exchange rae marke nor analyzes he relaionship beween rading volume and volailiy. 3. Daa The daa used o measure realized volailiy in his sudy are wo-minue observaions of he KRW/USD and JPY/USD spo exchange raes, provided by Delon Asse Managemen. 1 The sample period is from January 2, 2001 o April 22, The number of observaion days acually used for empirical analysis is 307, excluding weekends, legal holidays, and days in which he exchange rae showed obvious recording errors and in which no observaion was made. The number of sample m 1 The daa is Reuer screen oneand is available from he websie (hp://

7 observed in one day is 180, as he uni of daa is wo minues. 2 Therefore, he oal daa we use are =55,260 observaions. The daily realized volailiy is measured in realized variance, realized sandard deviaion, and realized log sandard deviaion, as in Andersen e al (2001a, b, 2003). Le us define he reurns of wo-minue exchange rae as ( 100 log ). The daily Y 180, realized volailiy can be measured by adding he squares of reurn of 180 observaions.3 In oher words, i can be calculaed from he wo-minue reurns of 180 T observaions: ( realized volaily ) = real = (100 logy + ( realized sandard deviaion) = sd j 1,...,180 (log realized sandard deviaion) = lsd = ( real ) 1/ 2 = log( sd 2 (180), 1 j /180 ) ) = 1/ 2log( real ) (1) <Table 1> Correlaion Among Three Volailiies real r2 garchv KRW/USD JPY/USD KRW/USD JPY/USD KRW/USD JPY/USD Real r garchv Noe: real=realized volailiy, r2= square of reurn, garchv=garch. Table 1 shows he correlaion beween wo very common volailiies GARCH and a simple square of reurns and realized volailiy. In KRW/USD, he correlaion coefficiens among he hree volailiy measuremens are abou 0.3, which is no enough o be judged as low or high. In JPY/USD, he absolue magniude of he correlaions are much smaller han hose of KRW/USD. The correlaion beween realized volailiy and hisorical volailiy (R2) is 0.26 which size is comparably similar o he number of KRW/USD. However, he one beween realized volailiy and garch volailiy shows 2 A day in his sudy means six hours, or he hours in which he exchange rae is observed. Alhough he marke opens a 9:30 a.m. and closes a 4:30 p.m., here is a one-hour break, oaling he observaion hours o six in one day. 3 A day in his sudy means six hours, or he hours in which he exchange rae is observed. Alhough he marke opens a 9:30 a.m. and closes a 4:30 p.m., here is a one-hour break, oaling he observaion

8 much differen size and opposie sign. Therefore, he simple correlaion resuls indicae ha he choice of volailiy migh poenially cause wrong implicaions in empirical analysis. As Figure 1 and 2 demonsrae, he wo volailiy measures, GARCH (garchv) and he simple square of reurns (r2), show similar movemens as he realized variance. Bu, in boh currencies, he condiional variances of he GARCH model seem o be oo much smoohing when compared o he realized variance. On he conrary, he hisorical volailiy has more erraic movemens han realized volailiy. Realized Volailiy (real) <Table 2> Basic Saisics Realized sd. (sd) Log sd. (lsd) Log spo vol. (lsvol) Log fuure vol. (lfvol) KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY Mean E E-15 Median Max Min Sd. Dev Skewness Kurosis Jarcque -Bera (00) (00) (00) (00) (0.155) (00) (00) (0.123) (0.658) (0.302) The basic saisics for informaion variables are described in Table 2. Trading volumes are measured in million USD and ransformed wih logarihm commonly used in he previous lieraure. Two exchange raes have slighly differen feaures in he basic saisics. In KRW/USD, among hree volailiy measures, logarihmic sandard deviaion of realized volailiy (lsd) does no display excess kurosis and is, hough, slighly skewed o he righ. We canno rejec he null hypohesis of normaliy, based on he Jarque-Bera es, of lsd. In JPY/USD, on he conrary, all volailiy measures do no have normal disribuion. We canno rejec normaliy of currency fuures rading volume of boh exchange raes and spo rading volume of JPY/USD. One noable hing is ha spo rading volumes of boh exchange raes are slighly skewd o he lef excep hours o six in one day.

9 JPY/USD s currency fuures rading volume. Table 3 shows uni roo es resuls. We canno rejec he hypohesis of no uni roo of lsd and he wo rading volumes of KRW/USD and JPY/USD. <Table 3> Uni Roo Tes Criical real sd lsd lr2 lsvol lfvol value (1%) KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY ADF PP Volume and Volailiy: Conemporaneous Relaionship In his secion, we analyze he conemporaneous relaionship beween foreign exchange rading volume and exchange rae volailiy of KRW/USD and JPY/USD. For robus check and comparison reason, we addiionally ake ino consideraion he logarihmic realized sandard deviaion ogeher wih he square of reurns of boh exchange raes. Table 4 shows he correlaion coefficiens beween informaion variables. We incorporae JPY/USD exchange rae ino our empirical analysis, since i has been argued in he previous lieraure 6 ha here are srong co-movemens beween he KRW/USD volailiy and ha of JPY/USD. 7 Someconspicuous resuls can be summarized as follows. Firs, in boh exchange raes, he correlaions beween rading volumes and volailiy are more ousanding in he case of currency fuures rading volume han spo rading volume, hough he magniude of he correlaion is differen in each exchange rae. In KRW/USD (JPY/USD), he correlaion coefficien beween currency fuures rading volume and realized volailiy is 0.44 (0.153), whereas ha beween spo rading volume and realized volailiy is relaively (slighly) lower, or 0.14 (0.147). Boh exchange raes records similar, in absolue magniude, size beween lsd 6 See Chung and Joo (1999). 7 JPY/USD s volailiy is measured by he square of reurns.

10 and spo rading volume. Second, he KRW/USD volailiy, eiher lsd or lr2, as expeced, has a posiive correlaion wih he JPY/USD volailiy (lydr2). Furher, while he correlaion coefficien beween currency fuures rading volume and JPY/USD volailiy is abou 0.1, here is no correlaion beween spo rading volume and yen-dollar volailiy. The correlaion analysis invies a quesion of wheher currency fuures rading volume is a more appropriae variable conveying informaion of boh domesic and overseas foreign exchange markes han spo rading volume. <Table 4> Correlaion beween Informaion Variables lsd lr2 lydr2 lsvol lfvol KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY lsd lr lydr lsvol lfvol Noe: lsd=(realized volailiy), lr2=(square of reurns), lydr2=(square of reurns of yen/dollar), lsvol=(spo volume), lfvol=(currency fuures volume). To find a deeper relaionship han jus he simple correlaion, if exiss, beween rading volume and volailiy in KRW/USD and JPY/USD foreign exchange mareks, we esimae an empirical relaionship specified wih he following equaion (2): volailiy m i= 1 [ volume ] ε ) = β 0 + β i volailiy + δ + (2 i where volailiy eiher sands for realized volailiy (lsd) or simple square of reurns (lr2), and volume means logarihmic spo rading volume (lsvol) or logarihmic currency fuures rading volume (lfvol). We include he lagged variables o ake ino consideraion he presence of serial correlaion in volailiy; rading volumes in he same period are used as an explanaory variable o examine he conemporaneous relaionship.

11 <Table 5> Empirical Resuls for Conemporaneous Relaionship β β 1 β 0 2 δ lsvol δ 2 lfvol R KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY lsd (-3.76) (-6.72) (-11.8) (-11.1) (6.842) (5.601) 77 (1.075) (1.784) (3.851) (2.889) (3.245) (1.870) (5.523) 53 (2.139) lr (-2.89) (-5.64) (-10.8) (-10.4) (2.169) 70 (1.188) (-1.46) -86 (-1.19) 78 (1.342) 45 (0.781) (2.351) (0.621) (4.303) (2.041) Noes: (1) Two lags based on BIC. (2) Values in parenhesis are -values. Empirical resuls for equaion (2) are summarized in Table 5. In KRW/USD, boh spo rading volume and currency fuures rading volume increase he curren volailiy. The hypohesis ha rading volume does no affec volailiies is rejeced a one percen significan level, regardless of eiher choice of volailiy or rading volume. The same analysis of JPY/USD share a common feaure of posiive relaion beween wo rading volumes and volailiies all bu he coefficien of JPY/USD spo rading volume is no significanly differen from zero. The coefficien of deerminaion is high when realized volailiy is used as dependen variable in boh exchange raes.. To check robusness or avoid possible wrong inerpreaion due o misspecificaion, we addiionally es he following equaion of (3-1) for KRW/USD and (3-2) for JPY/USD. KRW/USD case: volailiy = β + 0 m i= 1 + γ lydr2 β volailiy i + λ r + λ r I 1 i 2 + δ volume + ε (3-1) JPY/USD case: volailiy = β + 0 β volailiy + λ r + λ r I 1 m i= 1 i 2 + ε i + δ volume (3-2)

12 where lydr2 he square of reurns of JPY/USD, and r sand for and reurns (or log difference) of each exchange rae. For KRW/USD, we include one more variable of JPY/USD volailiy o reflec, if exiss, he effec of JPY/USD, an inernaional currency, on KRW/USD volailiy. The noaion I denoes an indicaor funcion wih one when each exchange rae depreciaes and zero oherwise. We specify equaion (3-1) based on empirical findings of lieraure such as Chung and Joo (1999). They argue wo hings: firs, here is a srong co-movemen beween volailiies of KRW/USD and JPY/USD. If JPY/USD s volailiy commonly affecs rading volume and volailiy of KRW/USD, hen he conemporaneous correlaion beween he wo variables of KRW/USD would be spurious. Second, here is asymmery in KRW/USD s volailiy. Tha is, volailiy of he depreciaion period is differen from ha of appreciaion. Thereby, equaion (3-1) would allow us o avoid misspecificaion in he volailiy process. <Table 6> Conemporaneous Relaionship wih Asymmery in Volailiy δ lsvvol δ γ lfvol λ 1 λ 2 1 λ2 λ + 2 R lsd KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY KRW JPY (2.75) (1.83) (4.12) 40 (1.60) 27 (2.34) 25 (2.21) (-3.6) (-3.0) (-3.1) (-2.9) (4.77) (4.11) (3.36) (2.94) (19.8) (16.1) (4.64) (4.41) lr (1.05) (7) 70 (0.41) -19 (-0.2) 10 (0.33) 08 (0.26) (-21) (-20) (-15) (-14) Noe: (1) Esimaion resuls β ' s are no repored here. (2) Values in parenhesis are -values excep for λ 1 + λ2 of λ + λ = λ + λ = (25.2) (24.4) (19.0) (18.2) (469) (452) (92.6) (87.1) , where F-values of he null hypohesis

13 Table 6 repors he resuls from equaion (3-1, 2). The resuls display some variaions across specificaions, bu he qualiaive conclusions appear robus. In boh KRW/USD and JPY/USD, here is asymmery in volailiy as found in he previous lieraure: each exchange rae s depreciaion resuls in larger volailiy burss han do he currency s appreciaion of he same magniude. Also, empirical resuls sugges ha he volailiy of KRW/USD increases, as does ha of JPY/USD. The asymmery and he Japanese yen s volailiy influence only apply o realized volailiy. One noable hing is ha he conemporaneous relaionship,commonly in boh exchange raes, disappears wih he square of reurns. Therefore, realized volailiy is a more useful and appropriae measure for invesigaing volume-volailiy relaionship. To summarize, he empirical resuls in his secion indicae a posiive conemporaneous dependence beween volailiy and he wo rading volumes. We now urn o he dynamic relaionship of volailiy and rading volume. 5. Volume and Volailiy: Dynamic Relaionship In his secion, we invesigae he dynamic relaionship beween rading volume and volailiy. Hence, a main quesion is o find, if exiss, a lead and lag or feedback relaionship or o have muually explanaory power wih some lags beween he wo variables. There are many ways o analyze iner-relaionships beween he wo variables. One simple bu useful empirical mehodology o uncover and compare iner-relaionships among he hree variables is he Granger causaliy es and impulse response funcion (IRF) ha are byproducs of vecor auo-regression (VAR) esimaion. The Granger causaliy ess provide informaion on causal or explanaory relaionships beween wo variables. The impulse response funcion shows he response of each variable o he srucural shock.

14 <Table 7> Resul of Granger Causaliy Tes Spo Volume Fuures Volume Fuures Volume Spo Volume KRW/USD JPY/USD KRW/USD JPY/USD Spo Volume Volailiy Volailiy Spo Volume lsd lr2 lsd lr2 KRW/USD JPY/USD KRW/USD JPY/USD KRW/USD JPY/USD KRW/USD JPY/USD Fuures Volume Volailiy Volailiy Fuures Volume lsd lr2 lsd lr2 KRW/USD JPY/USD KRW/USD JPY/USD KRW/USD JPY/USD KRW/USD JPY/USD Noe: Numbers are p-values of he null hypohesis of no Granger causaliy Table 7 summarizes he Granger causaliy ess beween volume and volailiy. 8 The resuls can be summarized by he following hree poins. Firs, in KRW/USD, here is no causal relaion beween currency fuures rading volume and spo rading volume in any direcion. In JPY/USD, here is, however, one uni-direcional causal relaion beween hem: currency fuures rading volume Granger cause spo rading volume. Second, here is no clear causal relaionship beween spo rading volume and exchange rae volailiy of KRW/USD, apar from he fac ha he relaionship in which realized volailiy of KRW/USD appears weakly o be useful for forecasing fuure values of spo rading volume of KRW/USD. Ineresingly, in JPY/USD, volailiy, boh lsd and lr2, srongly Granger causes spo rading volume, hough he degree of causaliy is much more srong wih lsd han wih lr2. Third, we canno rejec of he null hypohesis ha currency fuure volume does no Granger cause volailiy of KRW/USD bu he reverse relaionship is no rue. When realized volailiy is replaced wih a simple square of reurns, exchange rae volailiy precedes weakly (in he saisical sense), bu here is 8 In he VAR analysis, we se VAR lags o wo based on BIC. Empirical resuls for dynamic relaion are based on VAR(2).

15 a clear relaionship in which currency fuures rading volume precedes realized volailiy. However, here is no a causal relaionship beween currency fuures rading volume and exchange rae volailiy, regardless of choice of volailiy, in boh direcions for JPY/USD. Now le us look a he dynamic relaionship beween rading volume and exchange rae volailiy hrough impulse response analysis. Figures 3 hrough 6 show he impulse response funcions of KRW/USD foreign exchange marke along wih asympoic wo sandard deviaion errors. 9 To check he sensiiviy of resuls o he imposed ordering, we ake ino consideraion eigh pairs of volume and volailiy. 10 Figure 2 shows he impulse response funcions of currency fuures volume and realized volailiy o wo srucural shocks: he op panel is for (volume, volailiy) ordering and he boom panel is for he reversed ordering. From Figure 3, we can easily see ha here is a feedback relaionship beween currency fuures rading volume and realized volailiy, as he shock from each variable has a spillover effec on he oher variable in a posiive direcion. This resul is no affeced by he ordering of VAR variables. In response o he volume shock, volailiy iniially increases and hen gradually drops o zero afer abou en days. In response o he volailiy shock, fuures volume increases for wo or hree days and hen gradually drops o zero afer abou seven days, which is clearer wih (volailiy, volume) ordering. Figure 4 shows he impulse response funcions of realized volailiy and spo rading volume. Responses of he wo variables o shocks are no sensiive o he ordering of variables. Spo volume does no respond o volailiy shock. In response o volailiy shock, spo volume iniially increases bu hen drops quickly o zero afer one day. Figure 5, illusraing he resul of he impulse response funcion using currency fuures rading volume and he variable defined by square of reurns, may seem similar o feaures of figure 3 of wih realized volailiy, bu he feedback effec is somewha irregular and duraion is shor when compared o he case using realized volailiy. In Figure 6, where spo rading volume and square of reurns are used o define volailiy, he analyical resul is similar o ha of Figure 4, ha is, wih no clear spillover effec found in boh direcions. 9 Sandard errors are calculaed from he Mone Carlo simulaion of sandard 100 runs.

16 For he impulse response analysis of JPY/USD, he resuls are dramaically differen from he KRW/USD case. Impulse responses of he case of JPY/USD are depiced in figures 6 hru 9. There is no clear dynamic relaionship beween volume and volailiy excep beween spo rading volume and realized volailiy. In response o he realized volailiy shock, spo rading volume has clear response regardless of variable ordering.. Afer wo days, he response of he spo volume reaches peak and hen sharply drops o zero afer hree days. When he realized volailiy is replaced wih simple squre of JPY/USD s reurns, he dynamic relaion does no hold. Currency fuures volume and volailiy do no exhibi any feedback relaionship, which is very differen from he case of KRW/USD. In sum, he dynamic relaionship beween rading volume and volailiy very much depend on he choice of volume, volailiy and exchange rae. From he dynamic relaionship analysis of KRW/USD, we can see ha currency fuures rading volume and volailiy have feedback effecs upon each oher even hough he feedback effecs are weak wih spo rading volume. When comparing his resul wih ha of he conemporaneous correlaion analysis, we find no clear paern of a dynamic relaionship beween spo rading volume and exchange rae volailiy in boh direcions, by which we cauiously argue ha he effec of spo rading volume on exchange rae volailiy is limied o he conemporaneous relaionship. For JPY/USD, spo rading volume and volailiy have conemporaneous relaionship as well as dynamic one from volailiy o spo rading volume. The dynamic relaionship does no hold when realized volailiy is replaced wih a simple square of reurns of JPY/USD exchange rae ha is commonly used in previous lieraure. In KRW/USD foreign exchange marke, currency fuures rading volume has boh conemporaneous and dynamic explanaory powers wih regard o exchange rae volailiy. However, here is no any dynamic relaionship beween currency fuure rading volume and volailiy of JPY/USD. In sum, he currency fuures rading volume in Korea seems o, despie is small size, convey addiional informaion flows o spo volume in he Korean foreign exchange marke. The presence of he feedback effec suggess ha he informaion flowed ino he currency fuures marke is no immediaely absorbed by he price variable (exchange 10 Eigh pairs come from wo volumes and wo volailiies wih changing orders

17 rae) and needs a considerably ime, en days, say, before being refleced in he marke. Such a resul adds persuasive weigh o he mixure of disribuion hypohesis for he spo KRW/USD foreign exchange marke. On he oher hand, currency fuure markes for KRW/USD would be more appropriaely delineaed, if needed, wih a sequenial informaion arrival model, as argued by Copeland (1976), where informaion spreads sequenially o oher marke paricipans. The resul of JPY/USD migh be easily inerpreed: he increase in volailiy of JPY/USD may raise he demand of hedging insrumens ha resuls in higher ransacions of JPY/USD spo. The appropriae marke microsrucure model for JPY/USD is no clear. The model should incorporae no only conemporaneous relaionship beween volume and volailiy as well as have informaion (or news arrival) variable ha iniially influence only on volailiy.

18 6. Conclusion This aricle invesigaes he empirical relaionship beween rading volume and spo Korean won and Japanese yen agains US dollar exchange rae (KRW/USD and JPY/USD, respecively). We analyze he relaionship using wo differen rading volumes spo and currency fuures and he realized volailiy measured by high-frequency (wo-minue) daa. Empirical resuls sugges here is a conemporaneously posiive correlaion beween he wo rading volumes and volailiy. The realized volailiies of KRW/USD and JPY/USD exchange raes have posiive relaionship wih boh he spo rading volume and currency fuures rading volume conemporaneously. In boh exchange raes, such a relaionship, however, does no appear consisenly when square reurns are used as a proxy for volailiy. To check he robusness of he resul, we esimae various specificaions such as volailiy asymmery. We confirm he resul and find volailiy of depreciaion period is much higher han ha of appreciaion. Two exchange raes show dynamically differen volume and volailiy relaionship. Tha is, he wo volumes have dynamically differen informaion conen on volailiy. There is a clear lead-lag relaionship beween currency fuures rading volume and volailiy of KRW/USD, which is no he case wih spo rading volume and wih JPY/USD. For KRW/USD, he currency fuures rading volume, unlike he spo rading volume has a feedback relaionship wih realized volailiy. The effec of he shock of currency fuures rading volume on realized volailiy of KRW/USD las en or more days. Therefore, despie he fac ha he currency fuures rading volume is smaller han he spo rading volume in Korea, i is considered a highly useful variable ha faihfully reflecs he flow of new informaion moving ino he foreign exchange marke. For JPY/USD, we find only dynamically uni-direcional relaionship lasing wo days from realized volailiy o spo rading volume. Therefore, he empirical resul of JPY/USD, along wih conemporaneous relaionship beween spo rading volume and realized volailiy, can be inerpreed as following. When new informaion arrives in foreign exchange marke, he variable affecs commonly on boh spo volume and volailiy. The uncerainy, as measured by volailiy, incurs hedging demand such as opions or forward bu no currency fuures, which resuls in increasing in spo rading volume.

19 As such, our sudy is supporive of he mixure of disribuion hypohesis in he KRW/USD spo foreign exchange marke. Also, currency fuures volume conveys addiional informaion regarding price formaion, despie is relaively small size. For JPY/USD, heoreical model should no only conain conemporaneous relaionship beween spo rading volume and volailiy bu also conain informaion variable ha affecs asymmerically on hem in dynamic way. One clear cavea in our empirical resuls emphasize ha a beer characerizaion of reurn volailiy is needed o es heoreical explanaions such as he mixure of disribuion or sequenial informaion hypohesis. In policy perspecive, he difference in boh foreign exchange markes comes eiher (or boh) from under developed hedging markes or from marke inefficiency in KRW/USD foreign exchange marke. On he conrary, JPY/USD currency is inernaionalized one and is rading around 24 hours a day. We believe ha i is impossible informaion in he marke disseminae a very slow pace, which allow arbirage profi. I is inriguing quesion why here exiss he feedback relaionship beween he currency fuures rading volume and volailiy las over a considerable span of ime. A deailed sudy is necessary o verify he exac source of prolonged dynamic relaionship beween hem.

20 References Andersen, T. and T. Bollerslev (1998), Answering he Skepics: Yes, Sandard Volailiy Models Do Provide Accurae Forecass, Inernaional Economic Review, 39, Andersen, T.G. and T. Bollerslev, F.X. Diebold (2002), Parameric and Nonparameric Volailiy Measuremen, NBER Technical Working Paper No, 279. Andersen, T.G. and T. Bollerslev, F.X. Diebold and H. Ebens (2001), The Disribuion of Realized Sock Reurn Volailiy, Journal of Financial Economics, 61, Andersen, T.G. and T. Bollerslev, F.X. Diebold and P. Labys (2000), Exchange Rae Reurns Sandardized by Realized Volailiy are (Nearly) Gaussian, Mulinaional Finance Journal, 4, Andersen, T.G. and T. Bollerslev, F.X. Diebold and P. Labys (2001a), The Disribuion of Realized Exchange Rae Volailiy, Journal of he American Saisical Associaion, 96, Andersen, T.G. and T. Bollerslev, F.X. Diebold and P. Labys (2003), Modeling and Forecasing Realized Volailiy, Economerica, 71(2), Barndorff-Nielsen, O.E. and N. Shephard (1998), Aggregaion and Model Consrucion for Volailiy Models, Manuscrip, Deparmen of Mahemaical Sciences, Universiy of Aarhus, and Nuffield College, Oxford. Bollen, B., and B. Inder (1999), Ex Pos, Uncondiional Esimaors of Daily Volailiy, Manuscrip, Deparmen of Economerics, Monash Universiy. Campbell, J.Y., S.J. Grossman, and J. Wang (1993), Trading Volume and Serial Correlaion in Sock Reurns, Quarerly Journal of Economics, 108, Charah A., S Ramchander, and F. Song (1996), The Role of Fuures Trading in Exchang Rae Volailiy, Journal of Fuures Markes, 16, Charah A., and F. Song (1998), The Currency Fuures Marke and Inerbank Foreign Exchange Trading, Journal of Fuures Markes, 5, Clark, P. K. (1973), A Subordinaed Sochasic Process Model wih Finie Variance for Speculaive Prices, Economerica, 41, Dumas, B. (1996), Commen on Philippe Jorion, The Microsrucure of Foreign Exchange Markes, Frankel, J., Galli, G., Giovannini, A., eds. Universiy of Chicago Press. Engle, R.F. (1982), Auoregressive Condiional Heeroskedasiciy wih Esimaes of he Variance of UK Inflaion, Economerica, 50, Epps, T. W., and M. L. Epps (1976), The Sochasic Dependence of Securiy Price Changes and Transacion Volumes: Implicaions for he Mixure of Disribuion Hypohesis, Economerica, 44, Fung, H.G., and G. A. Paerson (1999), The Dynamic Relaionship of Volailiy, Volume, and Marke Deph in Currency Fuures Markes, Journal of Inernaional Financial Markes, Insiuions and Money, 9, Galai, G. (2000), Trading Volumes, Volailiy and Spreads in Foreign Exchange Markes: Evidence from Emerging Marke Counries, BIS Working Papers, No. 93.

21 Grammaik, T., and A. Saunders (1996), Fuure Price Variabiliy: A Tes of Mauriy and Volume Effecs," Journal of Business, 59, Harmann, P. (1998), Trading Volumes and Transacion Coss in he Foreign Exchange Marke: from he Shor-Run o Long-Run, Currency Composiion and Foreign Exchange Markes, Cambridge Universiy Press (1999), Trading Volumes and Transacion Coss in he Foreign Exchange Markes: Evidence from Daily Dollar-Yen Spo Daa, Journal of Banking and Finance, 23, Jorion, P. (1996), Risk and Turnover in he Foreign Exchange Marke, The Microsrucure of Foreign Exchange Markes, Frankel, J., Galli, G., Giovannini, A., eds. Universiy of Chicago Press. Lee, B. S., and O. M. Rui (2002), The Dynamic Relaionship Beween Sock Reurns and Trading Volume: Domesic and Cross-counry Evidence, Journal of Banking and Finance, 26, Tauchen, G. E., and M. Pis (1983), The Price Variabiliy-Volume Relaionship on Speculaive Markes, Economerica, 51,

22 <Figure 1> Realized Volailiy and Oher Measures of Volailiy(KRW/USD) Noe: The erm real, GARCHV, and R2 sand for realized volailiy, GARCH, and square of reurns, respecively.

23 <Figure 2> Realized Volailiy and Oher Measures of Volailiy (JPY/USD) REAL GARCHV REAL R2 Noe: The erm real, GARCHV, and R2 sand for realized volailiy, GARCH, and square of reurns, respecively.

24 <Figure 3> Impulse Response Funcion wih Realized Volailiy (KRW/USD) (a) Ordering: (fuures volume (LFVOL), realized volailiy (LSTD)) (b) Ordering: (realized volailiy (LSTD), fuures volume (LFVOL)

25 <Figure 4> Impulse Response Funcion wih Realized Volailiy (KRW/USD) (a) Ordering: (spo volume (LSVOL), realized volailiy (LSTD)) (b) Ordering: (realized volailiy (LSTD), spo volume (LSVOL))

26 <Figure 5> Impulse Response Funcion wih Square of Reurns (KRW/USD) (a) Ordering: (fuures volume (LFVOL), square of reurns (LR2)) (b) Ordering:( square of reurns (LR2), fuures volume (LFVOL))

27 <Figure 6> Impulse Response Funcion wih Square of Reurns (KRW/USD) (a) Ordering: (spo volume (LSVOL), square of reurns (LR2)) (b) Ordering:( square of reurns (LR2), spo volume (LSVOL))

28 <Figure 7> Impulse Response Funcion wih Realized Volailiy (JPY/USD) (a) Ordering: (fuures volume (LFVOL), realized volailiy (LSTD)) Response o One S.D. Innovaions ± S.E. Response of LFVOL o LFVOL Response of LFVOL o LSTD Response of LSTD o LFVOL Response of LSTD o LSTD (b) Ordering: (realized volailiy (LSTD), fuures olume(fvol)) Response o One S.D. Innovaions ± S.E. Response of LSTD o LSTD Response of LSTD o LFVOL Response of LFVOL o LSTD Response of LFVOL o LFVOL

29 <Figure 8> Impulse Response Funcion wih Realized Volailiy (JPY/USD) (a) Ordering: (spo volume (LSVOL), realized volailiy (LSTD)) Response o One S.D. Innovaions ± S.E. Response of LSVOL o LSVOL Response of LSVOL o LSTD Response of LSTD o LSVOL Response of LSTD o LSTD (b) Ordering: (realized volailiy(lstd),spo volume (LSVOL)) Response o One S.D. Innovaions ± S.E. Response of LSTD o LSTD Response of LSTD o LSVOL Response of LSVOL o LSTD Response of LSVOL o LSVOL

30 <Figure 9> Impulse Response Funcion wih Square of Reurns (JPY/USD) 2) JPY/USD (a) Ordering: (fuures volume (LFVOL), square of reurns (LR2)) Response o One S.D. Innovaions ± S.E. Response of LFVOL o LFVOL Response of LFVOL o LR Response of LR2 o LFVOL Response of LR2 o LR (b) Ordering:( square of reurns (LR2), fuures volume (LFVOL)) Response o One S.D. Innovaions ± S.E. Response of LR2 o LR2 Response of LR2 o LFVOL Response of LFVOL o LR2 Response of LFVOL o LFVOL

31 <Figure 10> Impulse Response Funcion wih Square of Reurns (JPY/USD) (a) Ordering: (spo volume (LSVOL), square of reurns (LR2)) Response o One S.D. Innovaions ± S.E. Response of LSVOL o LSVOL Response of LSVOL o LR Response of LR2 o LSVOL Response of LR2 o LR (b) Ordering:( square of reurns (LR2), spo volume (LSVOL)) Response o One S.D. Innovaions ± S.E. Response of LR2 o LR2 Response of LR2 o LSVOL Response of LSVOL o LR2 Response of LSVOL o LSVOL

32