Inflation Differentials and Excess Returns in the European Monetary System

In this paper, the relationship between excess returns on foreign exchange investment and inflation differentials and a measure of volatility is investigated for the European Monetary System. A high inflation rate relative to Germany leads to a real appreciation relative to the D-mark, which might increase the probability of a parity adjustment. As a consequence, investors will demand a risk premium leading to a higher interest rate on the weak currency. The excess return remains on the weak currency as long as this currency is not devalued. If the currency is devalued however, the loss can be considerable, especially if the timing of the devaluation was not foreseen by the market. These two effects are modelled by means of a mixture of normal distributions with endogenized weights that depend on the inflation differential. As a measure of volatility, the conditional variance of excess returns is included as an explanatory variable in the model. Using weekly D-mark rates of the Belgian franc, the Dutch guilder, the French franc and the Italian lira, it is shown that high inflation differentials are accompanied by high expected excess returns, but also high risk.