From Where Does it Come? An Analysis of Currency Market Volatility in Sri Lanka

Exchange rate volatility is a key concern of policy makers. Existing literature has identified a large set of variables as the determinants of exchange rate volatility. However, it is argued that there are common shocks that underlie the co-movements of large time series used in such studies. Using the latent factor approach, which is naturally structured to identify such common shocks, this paper disentangles the unconditional volatility of six currencies expressed against the Sri Lankan rupee into common, numaraire and idiosyncratic factors to identify the sources of currency market volatility in Sri Lanka during the period from 2002–2012. Specifically, this paper attempts to investigate whether the volatility of currency market in Sri Lanka stems from domestic currency market specific sources or external sources. Care is taken to distinguish the effects on intervention and non-intervention days. Empirical results suggest that currency market volatility in Sri Lanka is primarily externally sourced. Prior to the financial crisis, policy makers are found to have been primarily focused on mitigation of the volatility coming from the US currency market, whereas during the crisis this was expanded to include volatility emanating from European currency markets in what may be characterised as an attempt to minimise Sri Lanka’s exposure to global events at the time. However, the policy change introduced in early 2012 by limiting the Central Bank intervention in the foreign exchange market can be identified as an effective policy measure which has reduced exchange rate volatility arises in the domestic currency market.

Staff Studies Vol.42(1&2) 2012; 75-97