Response of tail risks of Euro-dollar exchange rate to monetary policy shocks in the US and the Euro area using penalized local projections

We estimate the impact of depreciation risks in the dollar per Euro exchange rate in response to both monetary policy shocks and central bank information shocks originating from the US and the Euro area. We utilize various sign restrictions on high-frequency data to effectively identify the shocks. To estimate the impulse responses, we employ the local projection methods along with the double lasso shrinkage procedure for control variables. It is found that monetary policy shocks result in the anticipated effects on the tail risk of dollar per Euro exchange rate solely during the contemporaneous period, irrespective of the structures of sign restrictions. In certain cases, reduction of tail risks is found in one to three-quarters after instances of tightening in US monetary policy, implying possible Euro’s characteristics of a safe haven asset. We also observe that US central bank information shocks decrease the exchange rate risks in the immediate period, promptly becoming insignificant thereafter.