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

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.