Financial Markets and Instruments FIN 3560 – 01 Professor Michael A. Goldstein, PH.D. The Effect of Interest Rates on the Euro’s Foreign Exchange Rate Andrea Canavesio Joseph Hage Chahine Felipe Piedrahita 12/5/2011 I Table of Contents: Executive Summary…………………………………………………………………………………………………………………………………… Background of the Euro……………………………………………………………………………………………………………………………1 Brief history of the European Union and the Euro……………………………………………………………………….1 The Monetary Snake…………………………………………………………………………………………………….…………….1 The European Monetary System…………………………………………………………………………………….…………..2 The Exchange Rate Mechanism……………………………………………………………………………………….………….3 Euro Convergence Criteria…………………………………………………………………………………………………………..4 Current European Debt Crisis……………………………………………………………………………………………………………………5 Foreign Exchange Rates Theory……………………………………………………………………………………………………….………7 Short-run Exchange Rates…………………………………………………………………………………………………….…….7 Long-run Exchange Rates….………………………………………………………………………………………………………..8 Purpose of Analysis………………………………………………………………………………………………………………….…8 Variables…………………………………………………………………………………………………………………………………….9 EURIBOR………………………………………………………………………………………………………………….……..9 LIBOR……………………………………………………………………………………………………………………..………9 Federal Funds Rate……………………………………………………………………………………………….………..9 Inflation – Real and Expected …………………………………………………………………………………………9 GDP Growth………………………………………………………………………………………………………………….10 Analysis of the Euro-US Dollar exchange rate…………………………………………………………………………………………10 Analysis of Assumptions……………………………………………………………………………………………………………10 P-value…………………………………………………………………………………………………………………………10 1999 – 2011……………………………………………………………………………………………………………………………...11 Best fit………………………………………………………………………………………………………………………….11 Interest rates………………………………………………………………………………………………………………..11 Simple regressions……………………………………………………………………………………………………..…12 2000 – 2006 …………………………………………………………………………………………………………………………..…13 Best fit……………………………………………………………………………………………………………………….…13 Interest rates………………………………………………………………………………………………………………..13 Simple regressions………………………………………………………………………………………………………..14 2007 – 2011………………………………………………………………………………………………………………………………15 Best fit……………………………………………………………………………………………………………………….…15 Interest rates………………………………………………………………………………………………………………..15 Simple regressions……………………………………………………………………………………………………..…16 Conclusion………………………………………………………………………………………………………………………………………….….17 References………………………………………………………………………………………………………………………………………..……18 Exhibits……………………………………………………………………………………………………………………………………………….…19 Regression Outputs………………………………………………………………………………………………………………………………..21 1999 – 2011………………………………………………………………………………………………………………………………21 Simple regressions………………………………………………………………………………………………………..21 Multiple regressions……………………………………………………………………………………………………..23 2000 – 2006………………………………………………………………………………………………………………………………26 Simple regressions………………………………………………………………………………………………………..26 Multiple regressions……………………………………………………………………………………………………..28 2007 – 2011………………………………………………………………………………………………………………………………31 Simple regressions………………………………………………………………………………………………………..31 Multiple regressions…………………………………………………………………………………………………..…33 Executive Summary: In analyzing the Euro we have decided to focus on its history, theory behind short-run and long- run foreign exchange rates, and the factors that affect the foreign exchange rate of the Euro. History has provided us with a basis of understanding as to how the Euro has affected the economy of the Euro zone and it has shown us what the purpose of the creation of this currency was. In order to perform our analysis we also had to have a general understanding of how exactly foreign exchange rates are determined and what are the factors affecting changes in these rates. The purpose of our analysis was to determine if the theory behind foreign exchange rates holds true and to what extent do the variables that theoretically affect exchange rates actually affect them. Along with our analysis of how the theory behind foreign exchange rates holds in the real world we will also be looking at why the Euro is valued higher than Dollar even though the Euro zone economy is in worse shape than the American economy. Analysis of the variables that theoretically affect foreign exchange rates should provide us with an answer as to why the EUR-USD exchange rate has been behaving this way. The variables we believe are the equivalents of EUR-USD exchange rates according to theory are LIBOR, EURIBOR, the Federal Funds rate, Euro zone inflation and Euro zone GDP growth. In order to analyze the effect of each of these variables on the EUR-USD exchange rate we have run several regressions. These regressions have provided us with an answer as to what has the most significant factors of these foreign exchange rates. Our belief is that the Euro is valued higher than the US Dollar because interest rates are much higher than in the US. We believe these higher interest rates are much more attractive to foreign investors. This causes foreign investors to demand the Euro in the foreign exchange market which in turn leads to its appreciation. Through our analysis we will be able to determine if our hypothesis is correct. Background on the Euro Brief history of the European Union and the Euro The European Union along with the Euro’s conception can be traced back to the founding of the European Community in 1967, an entity comprising of the three main economic pillars of Europe at the time: the European Atomic Energy community, the European Economic Market, and the European Coal and Steel Community. In point of fact, the driving factor behind the creation of the EU was a political move aimed at creating an economic interdependence between European countries, particularly France and Germany, in order to avoid future wars given the disastrous consequences of World War II1. The European Economic Market laid ground for the European Monetary System (EMS) which aimed to create an integrative economic system by eliminating trade barriers, promoting fiscal integration, and reducing trade hindrances related to currency exchange rates fluctuations. By doing this, the EMS would be able to sustain European monetary stability, resulting in the creation of the European Currency Unit (ECU). Even though the ECU was not a currency in circulation, it had clear diversification advantages for foreign investors, particularly since the Bretton Woods Agreement ended the convertibility of the US dollar to gold in 19712. The Maastricht Treaty signed in 1992 led to the creation of the formal European Union, constituted of the euro zone and its anteroom, the European Exchange Rate Mechanism (ERM). The ERM’s long term role was to stabilize exchange rates among members of the euro zone and assist in the convergence of their economies in view of the upcoming integration of a unique currency, the Euro. On January 1st 1999, the Euro officially replaced the European Currency Unit at par, 1 Euro being equal to 1 ECU. However, it was not until 2002 that the Euro came into circulation under its fiduciary form. The Monetary Snake Recognizing the fact that they were not only mutual clients, but major reciprocal suppliers as well; Western European countries created the Snake in the Tunnel policy in 1972 in order to strengthen and protect the economic interests that tied them to one another. These countries realized their commercial trades were vulnerable to volatile exchange rates, and could be the target of speculation. The various European currencies involved were able to move ±2.25% relative to their central rate 1 Marc Levine, Francis Kim, and Joel Siegel. The CPA Journal, April 1999 <http://www.nysscpa.org/cpajournal/1999/0499/Departments/D440499.HTM> 2 Ibid 1 against the US dollar, thus creating a narrow band of fluctuation for the participating currencies, the Tunnel being the US dollar. However, European currencies had fluctuation margins of ±4.5% among one another in relation to the US dollar, and the ever expanding leniency of the bands ultimately brought the Tunnel to collapse3. Since its very beginning, the economic turmoil from 1972 to 1978 proved the Monetary Snake to be unsustainable. The British Pound had to be withdrawn from the Snake a month after entering it, and never made a comeback, destabilized by the 1973 oil crisis and later hit by the 1976 Sterling crisis. Merely a year after its entry to the Snake in 1973, the Italian Lira had to exit, followed by the French Franc in 1974, and again later in 1976. By 1977, the Deutsche Mark was still following the Snake and dominating the Tunnel, and only three other currencies were able to keep up with the constraints. The necessity to elaborate a new monetary system was clear; a system that would prevent the Deutsche Mark from rising too high by weighting it to the weaker currencies of Germanys’ economic partners4. The European Monetary System: The European Monetary System (EMS) was introduced in 1979 after the notable failure of the Snake in the Tunnel policy. The EMS brought two main technical modifications building on the malfunctions of the Snake. First, instead of referring to the US Dollar, the currencies of the new system would use the newly created European Currency Unit (ECU) as a benchmark. The ECU was comprised of a weighted basket of currencies determined by the economic size of each participating EC member. Members of the EC could deposit gold and dollar reserves with the European Cooperation Fund for issuance of ECU currency, except for Greece which did not