The 1991 Treaty on European Union (the Maastricht Treaty) set January 1, 1999, as the starting date for the final stage in the creation of the European Monetary Union (EMU). On that date, the exchange rates between EMU participants will be irrevocably fixed. This will start the transition toward a unique currency, the Euro, expected to become the sole legal tender for EMU participants by 2002.

Illustration by James Freed

Most advocates of the EMU describe the introduction of the Euro not as a major currency reform, but rather as a currency changeover that will simplify international transactions and increase market liquidity by eliminating conversion costs and exchange rate risk. This, in turn, should provide a boost to international investments and to the overall level of economic activity. But will the adoption of the single European currency and the subsequent elimination of intra-European currency risk really have an effect on the international investor?

The Impact of the Euro on International Financial Markets

We recently conducted a study to analyze the impact of a single European currency on international financial markets. We performed an in-depth investigation of the economic and statistical relevance of currency risk and of its EMU and non-EMU components for both European and non-European markets. Although a topic of considerable discussion in the press, political circles and among investment professionals, this issue has received little rigorous analysis thus far.

The relevant issues are: how important is the EMU currency risk both in absolute and relative terms compared to its non-EMU counterpart, and by how much have international investors been rewarded for their exposure to EMU currency risk? These questions can only be addressed by looking at past evidence. We examined equity and eurodeposit markets from 1974 to 1997. We used monthly returns on stock indices and one-month currency eurodeposits for six countries (France, Germany, Japan, the Netherlands, the United Kingdom and the United States) plus a value-weighted world index.

The Significance of Currency Risk

Several important results emerged from our investigation. First, we found that currency risk is an important component of the overall risk of any financial asset. Exchange rate volatility induces systematic fluctuations in security returns, and the currency risk component commands an economically significant reward or premium in the market.

In addition, currency risk and its impact on returns vary over time as a function of changes in economic conditions and the institutional environment. Therefore, the reward that investors get for that exposure changes as market conditions change. In particular, the risk exposure of international markets to the EMU currencies has declined significantly since 1990. Over the same period, on the other hand, the exposure of financial markets to non-EMU currencies like the U.S. dollar, the yen and the pound has significantly increased.

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