Derivatives Trading and Volatility in Foreign Exchange Markets

This paper examines the relationship between the trading activities of futures contracts and their underlying currency volatility for the Euros, British pounds, Swiss franc, Japanese yen, and Canadian dollars traded on the Chicago Mercantile Exchange (CME). Following Bessembider and Seguin (1992, 1993), we decompose the volume and open interest into expected and unexpected portions to measure the different impacts depending on the nature of the shocks. We generally find positive contemporaneous relationships between the currency volatility and the futures volume while the relationship is negative between the volatility and open interest. This implies that the speculative activities, as proxied by the volume, tend to increase the spot currency volatility while the hedging activities, as proxied by the open interest, stabilize the currency markets. For the currency volatility and futures volume, we find two-way causality.