The euro and the volatility of exchange rates

Abstract

This article attempts to determine whether or not the introduction of the euro affected the volatility of major bilateral exchange rates. To this end, we examine the exchange rate behaviour for a set of Organization for Economic Co-operation and Development (OECD) and non-OECD countries during the period 1993 to 2010. We find evidence of structural breaks in volatility across investigated variables and, although there is a high heterogeneity regarding the located dates, our results suggest a reduction in volatility associated with European Economic and Monetary Union (EMU) and worldwide shocks and an increase in volatility following shocks originating outside EMU. The decomposition of total volatility into its components suggests that the permanent component tracks total volatility reflecting the evolution of fundamental factors, and the transitory component responds largely to market fluctuations, rising during the detected structural breaks.

Keywords:

• Euro
• multiple structural breaks
• volatility
• permanent and transitory volatility

JEL Classification:

• F31
• F33
• F40

Acknowledgements

The authors thank the editor and two anonymous referees for useful comments and suggestions. The authors are also grateful for the financial support from the Spanish Ministry of Science and Innovation (ECO2008-05565). The views expressed here are those of the authors and not necessarily those of the institutions with which they are affiliated.

Notes

¹ The impact of exchange rate volatility on international trade has been widely tested. Some recent examples are, Solakoglu et al. (2008), Aliyu (2010), Boug and Fagereng (2010) and Solakoglu (2010) among others.

² We are particularly grateful to Bai and Perron for providing us with the GAUSS code for computations.

³ Similarly, Stock and Watson (2002) use the absolute value of the fitted residuals of a Vector Autoregressive (VAR) model to analyse changes in variance. Alternatively, Valentinyi-Endrész (2004) use the squared errors from AR(1)-GARCH(1,1) model to compute changes in variance.

⁴ For further analysis, see Bai and Perron (1998, 2003).

⁵ We are grateful to an anonymous referee for suggesting this analysis.

⁶ This period differs between series depending on data availability.

⁷ This finding is in line with Lyons (2001) and Evans and Lyons (2002), who show that private information about the state of economic fundamentals is only gradually aggregated in the market and can generate exchange rate volatility.

⁸ It should be noticed that the launch of the ERM fostered economic integration and the co-ordination of economic policies in the EU, later formalized in a clear framework through the Maastricht Treaty.