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Emu, Exchange Rate Volatility and Bid-Ask Spreads

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  • Nuno Cassola

Abstract

This study deals with two issues related to the determination of exchange rate bid-ask spreads in the transition to EMU. First, we discuss how a credible announcement of conversion rates affects exchange rate volatility in the run up to the introduction of the Euro. Second, we discuss the theoretical relation that exists between exchange rate uncertainty and the bid-ask spread. The theory suggests that there is a positive association between exchange rate uncertainty and transaction costs and that we should observe a gradual reduction of exchange rate volatility in the transition to EMU. This theory implies a gradual shrinking of the bid-ask spread during the transition period. These conjectures are subject to empirical testing in the case of the exchange rate of the Portuguese escudo against the Deutsche Mark.

Suggested Citation

  • Nuno Cassola, 1998. "Emu, Exchange Rate Volatility and Bid-Ask Spreads," Working Papers w199805, Banco de Portugal, Economics and Research Department.
    • Handle: RePEc:ptu:wpaper:w199805
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    References listed on IDEAS

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    1. Copeland, Thomas E & Galai, Dan, 1983. "Information Effects on the Bid-Ask Spread," Journal of Finance, American Finance Association, vol. 38(5), pages 1457-1469, December.
    2. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
    3. Froot, Kenneth A. & Obstfeld, Maurice, 1991. "Exchange-rate dynamics under stochastic regime shifts : A unified approach," Journal of International Economics, Elsevier, vol. 31(3-4), pages 203-229, November.
    4. Gourieroux, C. & Monfort, A. & Trognon, A., 1985. "A General Approach to Serial Correlation," Econometric Theory, Cambridge University Press, vol. 1(3), pages 315-340, December.
    5. Krugman,Paul & Miller,Marcus (ed.), 1992. "Exchange Rate Targets and Currency Bands," Cambridge Books, Cambridge University Press, number 9780521435260, September.
    6. Paul Krugman & Marcus Miller, 1992. "Exchange Rate Targets and Currency Bands," NBER Books, National Bureau of Economic Research, Inc, number krug92-1.
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    1. Bernardino Adão & Jorge Barros Luís & Nuno Cassola, 1998. "Information on expectations about the escudo convergence from the volatility implied in currency options," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.

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