Volatility and the Euro: An Irish Perspective
27 Pages Posted: 12 Jul 2007
Date Written: February 17, 2000
With Ireland joining European Monetary Union (EMU) and adopting the euro, exchange rate risk between participating Member States is gone.1 However, as is known, this new currency will continue to face exchange rate risk, and any general reduction of volatility on a day to day basis for Irish economic agents neglects to take account of possible extreme problems with the euro. In this paper we will see that even though the euro is a managed, or irrevocably fixed, system, trade between Ireland and non-members, most notably the UK and the US, involves two separate currencies. This trade will require currency trading, leading to the possibility of large downside exposure to exchange rate risk for Irish firms. In addition, dealings in capital markets may be inhibited thereby reducing the funds available for investment purposes.
The issue of currency volatility is important for policy-makers as high levels will generally reduce economic growth. Causes of an economic slowdown may be due to a reduction in investment, or firms setting prices too high in an attempt to satisfy their risk averseness. Two recent examples of exchange rate volatility show the downside implications of large currency changes. First is the experience of the Mexican peso disaster that reduced that country's real output by 6 percent in 1995 (Source). 2 Second, with more relevance to the Irish economy, is the 1992/93 crises of the EU Exchange Rate Mechanism (ERM) where failed attempts to avert forced devaluations cost all participating members between 100 billion pounds and 150 billion pounds (Source). These two examples show the power of speculators in exchange rate trading, and there is no reason to believe that the creation of a single currency will eliminate this type of activity in the foreign exchange markets.
The methodological approach relied on in this paper is two-fold. First, conditional volatility is measured using a Generalised AutoRegressive Conditional Heteroskedasticity (GARCH) model. This will demonstrate the extent to which exchange rate movements have varied over time, with periods of low and high volatility. Second, exchange rate fluctuations are examined using Extreme Value Theory (EVT). This in essence determines exchange rate fluctuations allowing for the true data characteristics to be imbedded in the calculations.
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