Euro – Dollar Exchange Volatility and
Correlation with Crude Oil
Athanasios Konstantinidis
Master’s ThesisMaster in Strategy and Management of International Business
ESSEC Business School, Paris
Athanasios Konstantinidis
Supervisor: Declerck Francis
Paris, May 2008
Introduction: 4
Chapter 1: International Monetary Systems 5
1.1 The International Gold Standard (1879 – 1913) 5
1.2 The Inter-War Period, 1919-1939 6
1.3 Bretton Woods Agreement, 1944 7
1.4 The Fixed Rate Dollar Standard, 1950 – 1970 8
1.5 The Floating- Rate Dollar Standard, 1973-1984 10
1.6 The Plaza Intervention, 1985 – 1996 11
1.7 The European Monetary System, 1979 12
1.7.1 The European Currency Unit (ECU) 12
1.7.2 The Exchange Rate Mechanism (ERM) 13
1.7.3 The Exchange Rate Cooperation Fund (ERCF) 13
1.8 The European Monetary System, 1979 – 1998 14
1.8.1 The EMS Crisis of 1992 – 1993 15
1.9 The Path to European Monetary Union 16
1.10 European Economic and Monetary Union, 1999 17
Chapter 2: Foreign Exchange Market 18
Chapter 3: Theory 20
3.1 Financial Time Series: 20
3.2 Asset Returns 20
3.3 Stationarity 20
3.4 Volatility 21
3.4.1 Implied Volatility 21
3.5 GARCH - models 22
Chapter 4: Estimating and Modelling Volatility 23
4.1 Presenting Data 23
4.2 Descriptive Statistics and Plots 23
4.3 Estimating Volatility 24
4.4 Modelling Volatility 24
Chapter 5: The Relationship Between Crude Oil and Exchange Rate 26
5.2 Correlation Coefficient 27
Conclusion 30
Graphs and Tables 31
References 35
Introduction:
Since the breakdown of the Bretton Woods agreement in the early 1970s, currencies of the major industrial nations have fluctuated widely in response to trade imbalances, interest rates, commodity prices, war and political uncertainty. In recent years, the pressure of governments maintaining currency parity has led to the breakdown of quite a few exchange rate mechanisms and has, thus, reinforced the need for corporations, in particular, to take active foreign exchange hedging decisions in order to prevent the erosion of profit margins.
In a universe with a single currency, there would be no foreign exchange market, no foreign exchange rates, and no foreign exchange. But in our world of mainly national currencies, the foreign exchange market plays the indispensable role of providing the essential machinery for making payments across borders, transferring funds and purchasing power from one currency to another, and determining that singularly important price, the exchange rate. Over the past twenty-five years, the way the market has performed those tasks has changed enormously.
Since the early 1970s, with increasing internationalization of financial transactions, the foreign exchange market has been profoundly transformed, not only in size, but in coverage, architecture, and mode of operation. That transformation is the result of structural shifts in the world economy and in the international financial system.
In chapter 1, I briefly present the characteristics of various international monetary systems that took place in the modern world. At the chapter 2, I focus on the basic characteristics of foreign exchange market. The third and forth chapter cover volatility of exchange rates between European common currency (EUR) and US dollar. Then, in chapter 5, I try to observe and measure a possible relationship between exchange rates and crude oil by using as a background the meaning of correlation coefficient. Finally, the conclusion chapter includes the final results and remarks of that thesis.
Chapter 1: International Monetary Systems
1.1 The International Gold Standard (1879 – 1913)
The first modern international monetary system was the gold standard. Operating during the late 19th and early 20th centuries, the gold standard provided for the free circulation between nations of gold coins of standard specification. Under the system, gold was the only standard of value. Great Britain, with few interruptions, had already adopted the gold standard for more than a century. By 1879, that monetary system became increasingly international as many western and other industrial economies adopted this system. The United States, after the Civil War, in 1879 returned to gold standard and the value of paper money was tied directly to gold reserves in America.
The main features were a system of fixed exchange rates in relation to gold and the absence of any exchange controls. All countries had to fix an official price and allow free convertibility between their domestic currency and gold at that price. The United States in 1879 defined the price of one ounce at $20.67 and it remained until 1933. Other countries fixed their currencies in a similar way, which then determined exchange rates. Under the gold standard, a country with a balance of payments deficit had to surrender gold, thus reducing the volume of currency in the country, leading to deflation. The opposite occurred to a country with a balance of payments surplus. Gold reserves were responsible for the creation of money and the growth of it in the long run.
Under such conditions, the gold standard reveals the basic meaning of international reserves, exchange rates and capital flows. National economic policies were focused to justify a particular mint parity and central bank ready to lend freely to domestic banks with higher interest rate in short - run liquidity crisis from an international gold outflow. Finally, the worldwide price level was determined endogenously based on money demand and money supply.
In August 1914, the international gold standard ended abruptly as most European countries declared their willingness to convert their national currencies between each other. Thus, domestic macroeconomic policy started to be more important than international stable exchange rates. The gold standard of exchange sounded ideal, inflation was low, currency values were linked to a universally recognized store of value, and interest rates were low, meaning that inflation was virtually non-existent.
1.2 The Inter-War Period, 1919-1939
After the outbreak of the First World War, the gold standard was suspended as many countries abandoned it in favour of floating exchange rates. After the War, many exchange rates fluctuate sharply and most currencies experienced substantial devaluations against the dollar. In Europe, especially in United Kingdom, there was a widespread desire to return to the stability of the gold standard, and a worry about the growing attractiveness of the dollar, which was convertible into gold, and of dollar-denominated assets. United Kingdom re-established gold convertibility at the pre-war parity against the U.S. dollar and other nations followed Britain and went back to gold, but in many cases at devalued rates. During 1930s, some countries attempted to peg their currencies either with the dollar or the British pound instead of gold, but governments faced many difficulties in converting dollars or pounds at their promised exchange rates.
During the War, there were many attempts to influence exchange rates from countries and the distortions and disequilibria that had developed were not adequately reflected in the par values that were established in the mid-twenties. In an environment of severe global depression and a lack of confidence, the international monetary system disintegrated into rival currency blocs, competitive devaluations, discriminatory trade restrictions and exchange controls, high tariffs, and barter trade arrangements. As a result, of the instability in the foreign exchange market and the severe restrictions on international transactions during this period, the collapse of international trade and finance was not a surprise for the policymakers.
1.3 Bretton Woods Agreement, 1944
From 1943 to 1945, British and American negotiators worked continuously to draw up a new post-war monetary system by trying at the same time to increase the autonomy of national governments to determine their own monetary policies. In 1944, an international agreement called for fixed exchange rates between currencies. The Bretton Woods Agreement is named after the resort in New Hampshime where it was adopted along with the Articles of Agreement for the International Monetary Fund (IMF). It was an adjustable peg exchange rate regime operating under a gold exchange standard, with currencies other than the U.S. dollar convertible into the dollar, and the dollar, in turn, convertible into gold for official holders.
The economic debacle of 1930s supported that each country should have free rein to manage its own macroeconomics and exchange rates should be sufficiently flexible to support nationally selected inflation and employment objectives. Moreover, exchange rates should help for the stabilization of world trade. The Bretton Woods system of fixed but adjustable par values had some elements of the international gold standard and at the same time tried to establish a more flexible monetary system.
All countries had to fix a par value for the domestic currency with US dollar or a currency tied to gold. In the short run, currency values were allowed to fluctuate within a narrow 1 percent of its par value, but in long run that value could change in favour of fundamental disequilibrium, with the approval of the International Monetary Fund. Capital controls were necessary to avoid and or limit speculative attacks as free convertibility of currencies was possible between nations. Governments were able to offset short-run balance of payments imbalances by using their official reserves and International Monetary Fund’s credits. To achieve that goal, governments could intervene in the exchange markets and sterilize the impact of those interventions in the domestic money supply. Their objective is to offset the rise of base of the money supply rises and remove the newly created liquidity that came about from the foreign-exchange intervention.
1.4 The Fixed Rate Dollar Standard, 1950 – 1970
Even though that each country had to set its currency value in terms of gold, in practice, that monetary system evolved into a fixed-rate dollar standard, which required different rules for industrial countries and the United States. Industrial countries were permitted to set an official par value for their domestic currencies in terms of dollars and keep that value within 1% of that value indefinitely on either side of par value. Over twenty years, the exchanged rates remained stable and same except some few adjustments.
Each country should have structured its domestic monetary policy by subordinating the target of maintaining the fixed exchange rate and stable price of traded goods in the United States. As a consequence, countries other than United States abandoned their monetary policies in order to support fixed exchange rates and common price level for tradable goods. In contrast, the United States had to provide a stable world price level and monetary policy that satisfies all the countries and met their needs. The system worked well in the 1950s as both Europe and Japan found it convenient to rely on the United States to supply a stable price environment. In addition, the two stabilization plans, the Marshal in Europe and Dodge in Japan, supported the US$ as a unit of account and means of settlement. In the 1960s, both countries were hesitant to consider any exchange rate changes because large capital movements could be launched in anticipation of these changes.
By the 1960s, the accumulation of U.S. liabilities abroad continued, leading to the Triffin dilemma. As U.S. gold reserves progressively declined, and other nations’ holdings of dollar balances increased, questions arose about the ability of the United States to maintain the gold convertibility of the dollar. In order to prevent speculative conditions, the U.S policy makers impose restrictions on capital outflow and higher transaction costs from dollars to gold. The introduction of the special drawing right (SDR) was used as a paper gold substitute so as increase the supply of non dollar international reserves and provide a mechanism for expanding international liquidity without requiring additional U.S. payments deficits or additional dollar balances.
Over time, the dollar faced increasingly greater pressures, reflecting chronic U.S. payments deficits—in part associated with the fiscal consequences of the Vietnam War and new domestic social programs in the United States, but related also to the stronger competitive position of a restored Europe and Japan—and an international monetary structure that, in the view of most authorities, could not easily be modified to reflect the changing economic realities in the world economy. The expanding U.S. monetary policy in the late 1960s drove into higher inflation, 3.5 percent based on producer prices and 4.5 percent based on consumer prices and so caused a loss of price competitiveness for US exports. Following the years 1968 and 1969, the US trade balance and current account balance deteriorated sharply.
On August 15, 1971, the United States faced with rapidly mounting demands from other nations to convert their dollars into gold. Following the advice of economists throughout the United States who were worried about the America’s loss of international competitiveness, President Nixon announced a devaluation of the dollar, changing its official parity from 35 to 42 dollars per ounce of gold. In the next years, central banks allowed the exchange rates to float and find their equilibrium levels.
In December 1971, a meeting at the Smithsonia Institution resulted in a new set of exchange rate parities and a return to pegging. Specifically, the major industrial nations - Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom, and the United States - negotiated a multilateral realignment of exchange rates designed to eliminate the overvaluation of the dollar that had developed during the Bretton Woods par value regime, by devaluing the dollar and appreciating the par values or central rates of the currencies of certain other major industrial countries. New exchange parities were declared to value the dollar some 10 to 20 percent less against other important currencies. But those values broke down completely in early 1973, and the currencies of the major industrial blocks of North America, Europe and Japan had been floating against each other even since.
1.5 The Floating- Rate Dollar Standard, 1973-1984
The U.S. dollar continued to play the role of the most important currency in the world, for private and official purposes and for international transactions, better than any alternative. While the system was called floating, it was far from truly floating as policy makers were reluctant to allow the “private market forces” to define the value of exchange rates. This was not surprising, given the importance of exchange rates to an economy.
Under the floating rate dollar standard, industrial countries had the task of smoothing short run variability in exchange rates. Currencies remained convertible for current account transactions and countries should enhance the elimination of restrictions on capital account transactions. At the same time, the United States opened the access in their capital markets for borrowing and investing by private residents and foreign counterparties. Each country constructed its monetary policy independently and the United States did the same without paying attention for the exchange rate value, thereby not striving for common and stable price level for tradable goods.