Foreign Exchange Volatility and Trading

Volume of Derivatives Instruments:

Evidence from the Brazilian Market
Vinicius Ratton Brandi
Beatriz Vaz de Melo Mendes
Frederico Pechir Gomes
Marcelo Bittencourt Coelho dos Santos

ABSTRACT. The main objective of this work is to investigate the empirical relationship between trading volume and volatility. The understanding of foreign exchange market microstructure can provide better
understanding of its volatility, which may be useful to support market
intervention decisions made by the authorities responsible for conducting macroeconomic policies. Results show a positive contemporaneous
relationship between unexpected volume and volatility, suggesting simultaneous influence at the arrival of relevant information. Moreover,
they support the idea of market inefficiency, meaning that expected
volume also reveals a positive correlation with volatility.
Vinicus Ratton Brandi (E-mail: vinicus.brandi@bcb.gov.br) and Frederico Pechir
Gomes (E-mail: frederico.pechir@bcb.gov.br) are Assessors, both at the Department
of Financial Systems Guidelines, Central Bank of Brazil, Edificio Sede, 15 Andar,
SBS, Quadra 3, Brasilia DF 70074-900, Brazil.
Beatriz Vaz de Melo Mendes is Professor, Mathematics Institute, and Associate
Professor for Masters and Doctoral Studies, COPPEAD Institute, Universidade Federal
do Rio de Janeiro, Avda Pedro Calmon, 500, Prdio da Reitora, 2 Andar, Cidade
Universitria, Rio de Janeiro RJ CEP 21941-901, Brazil (E-mail: beatriz@im. ufrj.br).
Marcelo Bittencourt Coelho dos Santos is affiliated with the International Reserves
Department of Operations, Central Bank of Brazil, Edificio Sede, 5 AndarBloco B,
SBS, Quadra 3, Brazilia DF 70074-900, Brazil (E-mail: marcelo.santos@bcb.gov.br).
Latin American Business Review, Vol. 8(1) 2007
Available online at http://labr.haworthpress.com
2007 by The Haworth Press, Inc. All rights reserved.
doi:10.1300/J140v08n01_03

65

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LATIN AMERICAN BUSINESS REVIEW

RESUMEN. O objetivo principal deste trabalho investigar a relao

emprica entre volume de comercializao e volatilidade. A compreenso
da microestrutura do mercado de divisas pode fornecer uma compreenso
melhor de sua volatilidade, que pode ser til para respaldar decises de
interveno no mercado pelas autoridades responsveis por conduzir as
polticas macoeconmicas. Os resultados mostram uma relao contempornea positiva entre volume inesperado e volatilidade, sugerindo
uma influncia simultnea na chegada de informaes relevantes. Alm
disso, eles reforam a idia da ineficincia do mercado, significando
que o volume esperado tambm revela uma correlao positiva com a
volatilidade.
RESUMO. El objetivo principal de este trabajo consiste en investigar la
relacin emprica entre el volumen de transacciones y la volatilidad.
La comprensin de la microestructura del mercado cambiario puede
brindar un entendimiento mejor sobre su volatilidad, lo que a su vez puede
ser de utilidad para respaldar las decisiones tomadas por las autoridades responsables por la conduccin de las polticas macroeconmicas,
de intervenir en el mercado. Los resultados muestran una relacin contempornea positiva entre el volumen inesperado y la volatilidad, lo que
sugiere que existe una influencia simultnea a la llegada de la informacin
importante. Adems, ellos respaldan la idea de la ineficiencia del mercado, lo que implica que el volumen esperado tambin revela una
correlacin positiva con la volatilidad. doi:10.1300/J140v08n01_03 [Article copies available for a fee from The Haworth Document Delivery Service: 1-800-HAWORTH. E-mail address: <docdelivery@haworthpress.com>
Website: <http://www.HaworthPress.com> 2007 by The Haworth Press, Inc.
All rights reserved.]

KEYWORDS. Granger causality, foreign exchange market, price-volume relationship and market efficiency

INTRODUCTION
Blume, Easley and OHara (1994) suggest that price and volume are
jointly determined by the same market dynamics. According to Karpoff
(1987), the analysis of the correlation between price and volume may
lead to discrimination among different market microstructure hypotheses. The understanding of the relationship discussed herein is also
important for purposes of modeling the empirical distribution of speculative prices.

Brandi et al.

67

The present work focuses on the Brazilian FX market. Our aim is to

investigate the dynamic relationship between trading volume in the foreign exchange derivatives market and volatility in the BRL/USD exchange rate. It is worth mentioning that the complete understanding of
the FX market microstructure is a main concern for the monetary authorities in trying to conduct macroeconomic policies. Indeed, it can
lead to the identification of FX volatility determinants, which may be
useful for supporting market intervention decisions (BIS, 2005).
Our results show a positive contemporaneous relationship between
unexpected volume and volatility, suggesting a simultaneous influence
at the arrival of relevant information. Moreover, they support the idea of
market inefficiency, suggesting that expected volume also reveals a
positive correlation with volatility.
The remaining part of this paper is organized as follows. The second
section presents a brief review of the literature. The third section details
the data sample used to perform the analysis. Then, the fourth section
describes the methodology and shows the results. Finally, the fifth section states our concluding remarks.

LITERATURE REVIEW
Classical finance theory1 assumes that efficient price discovery (price
changes in efficient markets) may only happen when there is an immediate diffusion of new and relevant information. Therefore, assuming
that the occurrence of new information may also motivate new trades, it
is possible to find a bi-directional causality relationship between price
and volume, given that these two variables are dependent on the same
originating process.
More recently, different theoretical frameworks have been used to
explain the co-movement between trading volume and price volatility.
One of them refers to the inventory effect, which means that market
makers manage their liquid position in response to unexpected changes
in specific macroeconomic variables that determine the supply and demand of financial assets, and they move their bid-offer spreads around
the supposed expected/fair values in a way to induce the order flow.2
Conversely, information asymmetry models3 assume that new information is gradually diffused by market participants, affecting the price
discovery process through intermediate equilibria, until reaching a
full-information environment. Since agents may react to the arrival of

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new relevant information, thereby probably causing shifts in their demand curve,4 their actions will produce a positive correlation between
volume and volatility. Therefore, one can assume that past volume may
provide valuable information concerning absolute price changes.
Another theoretical explanation is based on the mixture of distribution hypothesis (MDH), which assumes that both volume and volatility
are driven by an unobservable common factor that reflects the arrival
and diffusion of new public information, and therefore establishes a
positive correlation between unexpected volume and volatility. In line
with previous works,5 Tauchen and Pitts (1983) developed the seminal
theoretical work in this literature, where they propose a model in which
volume varies over time due to a rise in the number of traders, the entry
of new information or the existence of heterogeneous expectations
among traders.
Corroborating the assumptions of the MDH, Frankel and Froot
(1990a, b) examine the relationship among the dispersion in expectations (survey forecast), volatility and volume, finding strong evidence
that the dispersion parameter, related to the divergence among market players beliefs, affects both volume and volatility. Fosters and
Viswanathan (1990) also present models where the dispersion of expectations causes not only a rise in price volatility but also excess volume.
The literature concerning the price-volume relationship in the stock
market is plentiful.6 Gallant, Rossi and Tauchen (1992), for instance, investigate this relationship in the US stock market based on a time series
covering the period from 1928 to 1985. Their results indicate that trading volume is positively and non-linearly related to the size of price
changes, which supports the hypothesis of the existence of a volume-volatility relationship for both unconditional and conditional distributions in cases where the returns are adjusted to an excess of kurtosis
and stochastic volatility.
For the Brazilian market, Tabak and Guerra (2003) examine the
price-volume relationship for 20 stocks traded on the Bovespa.7 Using a
linear bivariate VAR model, they find that price Granger-causes volume. Non-linear tests indicate strong evidence of bi-directional Granger
causality between the two variables.
With regards to the foreign exchange market, recent empirical evidence8 shows that FX rates present significant changes that are not
entirely explainable by macroeconomic fundamentals. Taylor (1995)
holds that speculative forces contribute to the discrepancy between FX
rates short-term behavior and behavior related to the macro fundamentals, which is normally modeled structurally.9 This explains why

Brandi et al.

69

the financial approach to FX rate changes and market microstructure investigation has gained academic importance in recent years, despite
representing a variable that holds a certain relationship with the fundamentals, especially in the medium and long terms.
Following this approach, an important work is the one by Galati
(2000), in which daily data from January 1998 through June 1999 are
used to investigate the price-volume relationship for seven currencies of
emerging economies. Unlike the other currencies analyzed, the hypothesis of a positive relationship between volume and volatility for the
Mexican Peso and the Brazilian Real was rejected.
Furthermore, Bjonnes, Rime and Solheim (2003) analyze the volume-volatility relationship in the Swedish FX market (SEK/EUR rate)
and find evidence that the participation of large banks is relevant for explaining the positive correlation between these two variables. The authors also argue that heterogeneous expectations consist of an important
aspect to be considered. Bessembinder, Chan and Seguin (1996) also
find that in both spot and futures market trading, volume varies positively with proxies for information flow. They also find that a rise in
trading volume is positively correlated to a proxy for the divergences of
opinion among traders, with a drop in trading volume being considered
unrelated.
In this regard, Lyons (1995), and Sarno and Taylor (2001) point to the
importance of investigating variables such as the information arrival process, agent behavior, order flow and player heterogeneity. The purpose is
to better understand the implications of market microstructure aspects on
price and volatility in the FX market.

DATA DESCRIPTION
Sample Size
The analysis covers the period from June 1, 1999 through June 21,
2005 for a total number of 1,464 daily observations. The sample size
selection was influenced by the exchange rate regime adopted by the
Brazilian authorities. Only data observed after the adoption of the
floating rate regime in January 1999 were considered. Additionally, in
order to avoid atypical fluctuations due specifically to the change in the
FX regime, June 1999 was chosen as the beginning month.10

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The sample data are composed of daily BRL/USD returns,11 with

Brazils country risk measured as the daily logarithmic return of the
EMBI Brazil Index12 and the volume, in BRL, of the more liquid
FX derivatives13 negotiated at BM&F.14 According to Garcia and Urban
(2004), the derivatives market is more liquid than the spot market.
Considering the period from 1993 to 2003, they verified that the trading
volume of the exchange rate futures first maturity was 2.7 times higher
than the volume of the spot market. According to the same authors,
Granger causality tests between prices in both markets find that the price
discovery process for the BRL/USD exchange rate takes place in the futures market, probably because of its higher liquidity and transparency.
The sample was also divided into two sub-periods: Period 1, from
June 1, 1999 to July 26, 2002, with 758 observations, and Period 2, from
August 9, 2002 to June 21, 2005, with 695 observations. This division
permitted the implementation of a complementary analysis by eliminating a 15-day period of unusual and extremely high volatility observed in
the second semester of 2002, caused by speculations involving the presidential election process. In addition, given that the Central Bank of
Brazil, through the regulation Circular 3.156, reduced the maximum
limit for the FX exposures of financial institutions from 60% to 30% of
the regulatory capital, the division adopted herein allows for the comparison between distinct regulatory environments.
Volatility
In the analysis, exchange rate volatility is used as the dependent variable represented by two different measuresthe BRL/USD exchange
rate absolute daily return |Rt| and the square of the daily return Rt2. Quadratic returns are used in order to emphasize the ones of large magnitude, regardless of their signs.
To control for the expected conditional volatility, which might not be
determined by the arrival of new information or by changes in market
agents expectations, the regressions that evaluate the contemporaneous
relationship between volume and volatility are estimated based on the
GARCH-M (GARCH-in-Mean) process introduced by Engle, Lilien
and Robins (1987), and which includes as a predictor of the conditional
mean past values of conditional standard deviation or conditional variance related to the GARCH process.

Brandi et al.

71

Volume
According to Tauchen and Pitts (1983), it is possible to perceive a
rise in volume due to an increase in the number of traders from a rise
caused by the arrival of new information. The rise related to the number
of participants is seen as the expected volume E(Vt), which must be
associated with the markets liquidity and should have a modest impact
on volatility. Conversely, the unexpected volume e(Vt), is influenced
by the arrival of new information and is important for explaining the
volume-volatility relationship, as observed by Bessembinder and Seguin
(1992) and Hartmann (1999).
The traditional methodology of Box-Jenkins (Box and Jenkins, 1978)
is used to split the data sets total volume into expected and unexpected
values. The purpose here is to obtain a parsimonious modeling of the
complete time series. Fitted values are defined as the expected values,
and the residuals are the unexpected values. Hartmann (1999) recommends the use of ARIMA (9.1.1) for the JPY/USD series. However, in the present work no evidence was found supporting better
modeling than ARIMA (2.2), which is the same conclusion reached by
Bjonnes, Rime and Solheim (2003). As the series of volume is stationary around a linear trend, we added a time variable to the ARIMA (2.2)
process. The ARCH structure was treated through a GARCH (1.1)
model.
Descriptive Statistics
Return and volume time series present the well known features already established as stylized facts of financial series, such as an excess
of kurtosis, fat tails and serial correlation, as presented in Table 1. The
normality hypothesis is rejected for all the variables by the Jarque-Bera
test (Jarque and Bera, 1980) at the 1% significance level. It should be remembered that, in this work, the EMBI variable represents the log return of the EMBI Brazil.
In order to avoid spurious results in our linear analysis, the unit root
was checked according to the augmented Dickey-Fuller test (ADF)
(Dickey and Fuller, 1979), with the lag length defined by the Akaike
information criterion (AIC). The unit root hypothesis is rejected for all
variables presented in Table 1 at the 1% significance level.

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TABLE 1. Descriptive Statistics
Average

SD

|Rt|

0.007181

0.007784

0.000112

0.000374

Rt

Asymmetry
3.171493
17.26186

E(Vt)

815.7922

2,248.480

2.048654

e(Vt)

543.1619

3,746.084

1.862322

EMBI+

0.000652

0.025987

Kurtosis
23.98995
449.4540
9.941701
10.50383

0.617596

5.644192

Note: Average, Standard deviation, Asymmetry and Kurtosis of absolute return series, quadratic return, ex+
pected volume, unexpected volume and EMBI return.

EMPIRICAL ANALYSIS
Contemporaneous Relationship
The contemporaneous relationship between volume and volatility is
analyzed according to the following regression:
s t = C + b 0 ht - 1 + b1 E(Vt ) + b 2e(Vt ) + b 3 EMBI t+ + et

(1)

where t represents the volatility on date t, and ht 1 is the estimate in

t 1 of the conditional volatility on date t. 0, 1, 2 and 3 are the coefficients of the explanatory variables, and t is a residual adjusted by a
GARCH (1, 1) process. In the regressions with the absolute return as the
dependent variable, h is given by the conditional standard deviation. In
those having the square of the returns as the dependent variable, h is
given by the conditional variance.
The models were estimated by maximum likelihood assuming innovations with normal distribution fitted by a GARCH (1, 1) process. Residuals do not present any particular pattern, a fact corroborated by the
traditional formal tests. Yet, it was verified that the explanatory variables of the equation (1) do not present any significant correlation. As
previously mentioned, with the aim of controlling for the expected conditional volatility, which is not associated with the arrival of new
prominent information models, regressions are estimated by a
GARCH-M process.
The EMBI variable is included to eliminate the country risk component of the exchange rate volatility, as documented by Garcia and
Lowenkron (2003). According to these authors, Brazil is one of the

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73

countries that verify the presence of the phenomenon known as cousin

risks, defined as the existence of a positive correlation between the
country risk and the exchange rate risk. They argue that whenever a
country faces an unbalance in its exchange rate exposure,15 an increase
in the expectation of exchange rate depreciation or in the exchange rate
risk intensifies the perception of future insolvency, elevating the sovereigns credit risk. On the other hand, it is reasonable to assume that
events that alter the probabilities of default of a determined country will
influence both exchange rate volatility and its level.
Considering the three periods studied, we test six models of regression, as shown in Table 2.
In general, the results indicate that at the 1% significance level there
is a positive relationship between volatility and the expected and
unexpected volume. Only the expected volume in the regression that
uses the absolute value of return presents no significance for period 1.
Based on the adjusted coefficient of determination (R2 Adjusted) for the
three periods in the analysis, the model considering the absolute return
as the volatility measure presented the best fit. The F test, which is also
TABLE 2. Contemporaneous Relationship Between Volatility and Volume
Explanatory Variables
Period Dependent
Variable

E(Vt)

e(Vt)

EMBI

R
Adjusted

All

0.955079*
(0.08792)

0.00064
(0.00034)

1.83E-7*
(3.98E-5)

1.20E-7*
(2.30E-8)

0.08357*
(0.0058)

3.3307

1.02404*
(0.1113)

0.00064
(0.00041)

9.76E-8
(8.77E-8)

2.84E-7* 0.08045*
(4.07E-5) (0.00764)

0.2413

1.1679*
(0.1927)

0.00145
(0.0009)

1.92E-7*
(5.41E-8)

9.94E-8* 0.07441*
(3.08E-8) (0.01036)

0.3104

All

R2

0.3370*
(0.026)

2.92E-6** 4.72E-9* 9.16E-10* 0.01964*

(1.21E-6) (2.72E-10) (1,82E-10) (0.0007)

0.1750

R2

0.1577*
(0.0292)

4.79E-6
(1.67E-6)

4.02E-9*
2.74E-9* 0.0179*
(5.86E-10) (3.91E-10) (0.0010)

0.0879

R2

0.5428*
(0.0748)

9.36E-6*
(5.82E-6)

2.25E-9*
1,12E-9*
(7.46E-10) (4.02E-10)

0.0135*
(0.016)

0.2465

Note: Coefficients of equation (1) estimated under GARCH (1.1) process, for different periods and volatility
measures. The h variable as square root of conditional variance for regressions with absolute return and
the own conditional variance for quadratic return. Standard Error in parenthesis.
*Statistically significant at 1% level.
**Statistically significant at 5% level.

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seen as a test of significance of R2, rejects, at the 1% significance level,

the null hypothesis that R2 is zero for each regression.
Concerning the unexpected volume, the results corroborate previous
tests performed in international markets, suggesting that both answer
simultaneously to the arrival of new information, which agrees with the
MDH. Galati (2000), on the contrary, examined the BRL/USD market
and verified a negative correlation between those variables, but without
any statistical significance. According to our evaluation, his result might
have been influenced by the short sample period, which was comprised of
two different exchange rate regimes and the overshooting of the exchange rate usually observed after regime transition. As the author points
out, the negative correlation elapses from the turbulence period in international markets, which affirms that the correlation should be positive
only during periods of normality, but negative in periods of stress.
Regarding the expected volume, a significant positive correlation
with volatility was observed. The MDH states that an increase in the expected volume elapses solely from an increase in the number of market
players, showing no relationship to market volatility. As a conclusion,
we could question the efficiency of the Brazilian foreign exchange market, as its price is influenced by factors not related to the arrival of new
information, such as an expected variable. This result may be corroborated by the common notion that this market presents low liquidity. As
suggested by Tabak and Guerra (2003), such a result could lead to the
conclusion that liquidity risk may be an important issue when building
risk management models. A theoretical explanation could be based on
information asymmetry models, which assume that the gradual diffusion of information among market agents could result in a spurious correlation between expected volume and volatility.
In line with the hypothesis of cousin risk, the EMBI showed a significant positive correlation in all the regressions.
Causality Test
The lagged relationship is investigated using Granger causality
(Granger, 1969). Although this test does not provide an idea of causeeffect in the economic sense, it can be very useful for indicating the
lagged relationship between variables, providing valuable information
about the microstructure of financial markets. The definition of the lag
length can be expert-based by using intuition to perceive what would be
the longest period of time that the movement in price of a variable will
forecast movements in the price of another variable. We have deter-

Brandi et al.

75

mined a maximum lag of 10 business days and the optimal lag length
k was chosen by AIC by implementing a bivariate VAR analysis. As
previously stated, the series are stationary, as indicated by an ADF test,
which validates the conventional test of Granger based on VAR with
variables on the level.
Basically, Grangers causality verifies whether the conditional variance of a dependent variable is significantly reduced after the inclusion
of past information about another variable and lagged observations of
the own dependent variable. As explained by Greene (2003), tests comparing restricted and extended regressions are based on the F test in the
equations of the VAR model.
In this study, the extended regression is defined as:
k

i=1

i=1

s t = a i s t - i + b iVt - i + ut

(2)

And the restricted regression as:

k

s t = g is t- i + vt

(3)

i=1

The statistical test is defined by:

T

l=

t=1

v t2 - t = 1 ut2 T - 2k - 1
T
k
u2

t=1

(4)

where ut and vt represent the residuals of the extended and restricted regressions, respectively, T is the sample size, represents the volatility
measure and V is the volume measure. The statistical test has an asymptotic F distribution (k, T 2k1). If the critical value of the F distribution for a determined confidence level is lower than the statistical
test, the null hypothesis will be rejected. The null hypothesis states that
the new explanatory variable included in the extended regression does
not Granger-cause the dependent variable.
Table 3 presents the results of the Granger causality test for the expected volume. As can be seen, for absolute returns the exchange rate
volatility Granger-causes E(Vt), which can be explained by agents
searching for a hedge in the derivatives market after observing an

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TABLE 3. Granger Causality Test Results

All

R Granger not cause E(Vt)

6.677*
(0.00018)

E(Vt) Granger not cause R

1.443
(0.22843)

R Granger not cause E(Vt)

5.9386*
(0.00053)

E(Vt) Granger not cause R

0.44124
(0.72358)

R Granger not cause E(Vt)

3.14572**
(0.02464)

E(Vt) Granger not cause R

All

R Granger not cause E(Vt)

1.019
(0.39618)

E(Vt) Granger not cause R2

3.70533*
(0.00523)

R Granger not cause E(Vt)

5.61165*
(0.00019)

0.65784
(0.62147)

R Granger not cause E(Vt)

0.69660
(0.59446)

0.43479
(0.78353)

E(Vt) Granger not cause R

2

0.49205
(0.6879)

E(Vt) Granger not cause R

Note: Test statistic and p-value (in parenthesis) of Granger causality test for the three periods in analysis
and with the expected volume as measure of volume.
*Statistically significant at 1% level.
**Statistically significant at 5% level.

increase in volatility (risk). Regarding the quadratic returns, the same

tendency was verified for period 1 only.
Table 4 presents the results of the Granger causality test for the unexpected volume. The Granger causality relationship was verified only for
period 1 at the 5% significance level, with the square returns as the
volatility measure. It is usually verified that there is no lagged relationship between volatility and unexpected volume, suggesting that the
information arrival process has simultaneously influenced both variables, which corroborates with our theoretical assumptions.

Brandi et al.

77

TABLE 4. Granger Causality Test Results

All

R Granger not cause e(Vt)

2.37624
(0.09410)

e(Vt) Granger not cause R

0.90498
(0.09967)
2.31302
(0.09967)
0.61162
(0.54274)
0.89216
(0.41024)
0.05708
(0.51952)
0.65515
(0.51952)
1.59506
(0.20325)
3.65666**
(0.02628)
0.11741
(0.88924)
0.03101
(0.96947)
0.12958
(0.87848)

R Granger not cause e(Vt)

e(Vt) Granger not cause R

R Granger not cause e(Vt)

e(Vt) Granger not cause R

All

R Granger not cause e(Vt)

e(Vt) Granger not cause R2

R2 Granger not cause e(Vt)

2

e(Vt) Granger not cause R

2

R2 Granger not cause e(Vt)

2

e(Vt) Granger not cause R

Note: Test statistic and p-value (in parenthesis) of Granger causality test for the three periods in analysis
and with the unexpected volume as measure of volume.
* Statistically significant at 1% level.
**Statistically significant at 5% level.

CONCLUSION
The classical market efficiency hypothesis assumes that the variation
of prices elapses only from the arrival of new prominent information.
The mixture of distributions hypothesis (MDH) assumes that volume
and volatility are both driven by a common and unobservable factor that
reflects the arrival of new public information and therefore generates a
positive correlation between unexpected volume and volatility. Conversely, information asymmetry models state that new information is
gradually diffused through the financial market, affecting the price discovery process through intermediate equilibria, until reaching a final
equilibrium, when complete information is available to all players.

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The main objective of this study has been to contribute to the literature
on the microstructure of foreign exchange markets, investigating the empirical relationship between trading volume and volatility. It is worth noting that the understanding of the FX markets microstructure can lead
to identifying possible causes for a rise in FX volatility, which may be
useful for supporting market intervention decisions made by the authorities responsible for conducting macroeconomic policies (BIS, 2005).
Previous research in this field shows a positive correlation between
volume and volatility in different markets. A prominent work on the
foreign exchange market is that of Galati (2000), in which there is no
verification of a significant relationship between volume and volatility
in the Brazilian market.
At the 1% significance level, the results in general indicate a positive
relationship between volatility and the expected and unexpected volume. Concerning the unexpected volume, results corroborate with previous tests performed in international markets, suggesting that both
answer simultaneously to the arrival of new information, in agreement
with the MDH. Regarding the expected volume, a significant positive
correlation to volatility was observed, suggesting that the efficiency of
the Brazilian foreign exchange market cannot be taken for granted. A
theoretical explanation for this could be based on information asymmetry models, which assume that the gradual diffusion of information
among market agents could result in a spurious correlation between expected volume and volatility.
Granger causality tests indicate that expected volume can be better
explained by lagged price volatility values, which could be explained by
agents searching for a hedge in the derivatives market after an increase
in volatility (risk). Regarding the unexpected volume, it has been verified that there is no lagged relationship between volatility and unexpected volume, suggesting that the information arrival process has a
simultaneous influence on both variables, contrary to the assumptions
of information asymmetry models.
Future research in this area could investigate aspects such as non-linearity and asymmetry in the relations between volume and volatility.
Regarding the data sampling, high frequency data could be used. Finally, others variables, such as proxies for the information arrival process, agent behavior, order flow or heterogeneity could be incorporated
into the analysis in order to promote a better understanding of the foreign exchange markets microstructure and its implications.

Brandi et al.

79

NOTES
1. See Samuelson (1965) and Fama (1970).
2. Evans and Lyons (1999) demonstrate that the variable defined in Lyons (2001)
as a variant of the concept of liquid demand is very important for explaining FX rate
changes.
3. Copeland (1976), Morse (1980), and Jennings and Barry (1983).
4. The trader behavioroptimism or pessimismwill determine the direction of the
curve shift.
5. While the model developed by Clark (1973) sees the volume as a proxy for determining how fast the information flows, Epps and Epps (1976) use volume to measure
the level of divergence among traders beliefs, since prices are revised given the arrival
of new information.
6. Rogalski (1978), Smirlock and Starcks (1988), Jain and Joh (1988). Hiemstra
and Jones (1994), Silvapulle and Choi (1999), Saatcioglu and Starks (1998), and Basi,
zyildirim and Aydogan (1996).
7. Bolsa de Valores de So Paulo.
8. See Frankel and Rose (1996), Taylor (1995), Flood and Taylor (1996), Lyons
(1995), and Lyons (2001).
9. Models that aim to explain the behavior of FX rates based on the behavior of
macroeconomic variables.
10. See Dornbusch (1976) for more information on market movements (overshooting) following a change in the FX regime.
11. Calculated as the logarithmic difference of the last prices provided by Bloomberg.

12. The Emerging Markets Bond Index PlusEMBI is calculated by JPMorgan

based on the returns of sovereign and quasi-sovereign instruments denominated in
USD (Bradies, Eurobonds, loans, etc.).
13. The instruments used in the analysis are futures and swaps. Futures are responsible for approximately 99% of the total volume.
14. Bolsa de Mercadorias e Futuros, the Brazilian derivatives exchange.
15. Measured as the difference between the foreign debt and the international reserves, both as a percentage of the GDP.

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Received: January 24, 2006

Revised: March 13, 2006
Approved: April 13, 2006
doi:10.1300/J140v08n01_03