On the Implied Foreign Exchange Rate Volatility: The Role of External Vulnerability Indicators and When They Count the Most?

Abstract

This paper studies the effect of external vulnerability indicators on the implied foreign exchange rate volatility. Controlling for a set of domestic and external macroeconomic factors and using options-implied volatilities, the results suggest that (i) market participants expect a lower future volatility in response to a decrease in current account deficit or an increase in international reserve adequacy; (ii) when global financial conditions are on the edge (when the VIX is above a certain threshold), both external vulnerability indicators imply a stronger effect on the future expected volatility (around twice as high, on average); (iii) these effects are by-and-large stronger for emerging market economies.