FOREIGN FORWARD EXCHANGE RATE RISK PREMIUM AND THE EMU EFFECT

During the early 1990s, the foreign exchange markets were the scenes of a number of acute speculative attacks directed against major currencies. In August 1993 the Exchange Rate Mechanism (ERM) was effectively suspended as bilateral bands were widened from plus/minus 2.25 percent to plus/minus 15 percent for the most of the remaining members. The ERM, whose purpose was to ensure currency stability, had been altered to such an extent that its member currencies were practically free-floating. Uncertainty about nominal exchange rates may interfere with European integration. In this project, we investigate whether the ERM has had an effect on the risk premium and unexpected changes in the future spot rates after the speculative crises. The presence of risk premiums in foreign exchange market has detrimental effects on international trade and, ultimately, employment, output and economic growth. In this project the existence of the risk premium in the foreign exchange market is modelled using a state space model and the Kalman filtering technique. We find that the movement towards the Monetary Union has influenced the risk of those currencies committed to participate in the first phase of EMU. The decreasing variability of the risk premium and the unexpected changes of the future spot rate can be explained with the EMU effect.