Explaining the dollar/euro exchange rate: the role of policy uncertainty, asymmetric information, and hedging opportunities

Many observers were surprised by the depreciation of the euro after its launch in 1999. Handicapped by a short sample, explanations tended to appeal to anecdotes and lessons learned from the experiences of other currencies. Now sample sizes are just becoming large enough to permit reasonable empirical analyses. This paper begins with a theoretical model addressing transaction costs of trading the euro. The model of pre- and post-euro foreign exchange trading explains wider spreads on the euro as a result of three possible causes: a reduction in hedging opportunities due to the elimination of the legacy currencies, policy uncertainty on the part of the ECB, and asymmetric information due to some traders having prior knowledge of ECB policies. However, even informal empirical evidence tends to reject the hypothesis that spreads were larger on the euro than the mark for all but the first few months. This seems like an unlikely candidate to explain euro depreciation over the prolonged period observed. After addressing spreads, the model is turned toward an explanation of the exchange rate level. By specializing the fundamentals considered to the euro-area inflation rate, the model is structured toward the dynamics of learning about ECB policy with regard to inflation. While a stated target inflation rate of 2 percent existed, it may be that market participants had to be convinced that the ECB would, indeed, generate low and stable inflation. The theory motivates an empirical model of Bayesian updating related to market participants learning about the underlying inflation process under the ECB regime. With a prior distribution drawn from the pre-euro EMS experience and updating based upon the realized experience each month following the introduction of the euro, the evidence suggests that it was not until the fall of 2000 that the market assessed a greater than 50 percent probability that the inflation process had changed to a new regime. From this point on, trend depreciation of the euro ends and further increases in the probability of the new inflation process are associated with euro appreciation.