Handbook of Exchange Rates

4.2 Exchange Rate Puzzles

4.2.1 Disconnect Puzzle and Excess Volatility Puzzle

The first stylized fact of the foreign exchange market is composed of two phenomena related to one another. They are the so-called disconnect and excess volatility puzzles. Empirical evidence shows that the market exchange rate is systematically disconnected from its fundamental, and furthermore, that it is considerably more volatile than its fundamental as well.

Figure 4.1 shows this feature for the US Dollar–Euro/Deutsche Mark exchange rate. The upper panel displays the exchange rate level (continuous line) versus its fundamental (dashed line) for the period January, 1993 until February, 2003. The figure shows that the market exchange rate was systematically disconnected from its fundamental over the whole sample period. This fundamental is obtained by Ehrmann and Fratzscher (2005) using a SVAR model, linking the exchange rate to observable macroeconomic variables.

Figure 4.1 Disconnect and excess volatility puzzles.

The lower panel of the same figure displays the (log) first differences of the two series shown in the upper panel, that is, the difference (in logs) of the exchange rate and the difference (in logs) of its fundamental between consecutive periods. The figure illustrates the excess volatility puzzle, which is closely related to the previous one. This second puzzle refers to the excess ...