Methodology

Foreign Exchange Markets

Diebold-Yilmaz Connectedness Index (DYCI) methodology is applied to daily US Dollar exchange rate return volatilities of 28 currencies over the period from January 1, 2000 through July 23, 2014. The results are based on generalized variance decompositions (with 10-day forecast horizon) obtained from a VAR(3) model of daily range volatilities. The VAR model is estimated using the elastic net shrinking and selection procedure, which combines Lasso and Ridge estimators.

Dynamic connectedness measures are obtained from the estimation of the VAR model over 200-day rolling windows. "Index" is the total connectedness measure. "To," "From" and "Net" are the "to," "from," and "net" directional connectedness measures calculated for each variable in the analysis.

Network graphs are created with Gephi (https://gephi.github.io/) open-source software for visualizing large scale network graphs. Node locations are determined using the ForceAtlas2 algorithm of Jacomy et al. (2014) as implemented in Gephi.

Node size indicates over-the-counter FX turnover of the currency as reported by the Bank of International Settlements. Node color indicates the "to" connectedness of the exchange rate volatility and varies according to the following color spectrum:

Edge thickness indicates the average edge weight, which happens to be the pairwise directional connectedness. In order to obtain a clear graphical image, we dropped the lower half of all edges after ordering them by their weights. Edge color does not vary with edge weight.

2014 by Francis X. Diebold and Kamil Yilmaz