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Modeling Exchange Rate Movements with Cross-Markets and Macroeconomics Variables

This paper proposes to model exchange rate movements by integrating cross-markets explanatory variables, such as country equity indices and commodity prices (crude oil) with macroeconomics variables such as inflation and interest rates. The empirical analysis is carried out through the vector autoregression (VAR) methodology, as well as Granger causality, cointegration tests, impulse responses and variance decomposition. The testing period is from January 1989 to October 2008, i.e, includes the recent financial crisis episode. Our universe is limited to the most liquid developed markets. We find evidence that the financial markets variables, individually and jointly, outperform the macroeconomics variables in determining exchange rates. The oil price has been the strongest driver for the US dollar, with soaring oil prices leading to dollar depreciation against the major currencies: EUR, GBP, JPY and CAD.