The Single European Currency and World Equity Markets

The objective of this study is to analyze the impact on world financial markets of the adoption of the Single Currency and the contemporaneous elimination of intra european currency risk. We estimate the EN11; and non-EMU components of aggregate currency risk using a conditional version of the international CARM of Adler and Dumas (1983). Our results indicate that investors are rewarded for their exposure to both sources of currency risk. The premium for EMU risk is mostly positive. but has decreased over the years. The non-EMU currency risk is consistently negative and is much larger. in absolute value, than its EMU counterpart. This suggests that the adoption of a single currency is likely to have a limited impact. European financial markets will still be exposed to the large and dominant impact of the non-EMU currency risk. *The first two authors are from the Marshall School of Business at the University of Southern California. the third author is from INSEAD. We thank the Bank of International Settlement in Basle for graciously providing some of the Eurocurrency deposit data and CIBEAR-USC for research support. Address correspondence to Giorgio De Santis, Marshall School of Business, Department of Finance and Business Economics, University of Southern California, Hoffman Hall 701. Los Angeles, CA 90089-1421. Tel. (213) 740-6538. e-mail: gdesantisemarshall.usc. edu. THE SINGLE CURRENCY AND EQUITY MARKETS 1 The 1991 'Meaty on European Union (Maastricht Treaty) set January 1, 1999 as the starting date for the final stage in the creation of the European Monetary Union (EMU). If the European Council decides to confirm the 1999 deadline, the exchange rates between ENru participants will be irrevocably fixed to start the transition toward a unique currency, the euro, which is expected to become the legal tender for EMU participants by the year 2002. Most advocates of the EMU describe the introduction of the euro not as a major currency reform, but rather as a currency changeover which will simplify international transactions and increase market liquidity by eliminating conversion costs and exchange rate risk. This, in turn, should provide a boost to international investments and to the overall level of economic activity. Although the arguments in favor of a unique European currency are intuitively appealing. a more thorough analysis of the concept of currency risk may be useful to better appreciate the relevance of the EMU to investors. In general, it is well known that the existence of uncertainty in financial markets is not necessarily bad. First, because it is often possible to hedge against it, at least in part. Second, because efficient financial markets reward investors for their exposure to systematic risk. In addition. despite the elimination of currency fluctuations within the EMU, European consumers will still be exposed to exchange rate uncertainty toward non-ENIU currencies like the U.S. dollar, the Japanese yen and the British pound. ' The price sensitivity of their consumption baskets with respect to such currencies is also an important factor in determining the effects of adopting the euro. Surprisingly, very limited empirical evidence is available on these issues. The main objective of this study is to analyze the impact on world financial markets of the adoption of a single European currency and the subsequent elimination of intra-European currency risk. We estimate the EMU and non-EMU components of aggregate currency risk using a conditional version of the international CAPM of Adler and Dumas (1983). Our results indicate that investors are rewarded for their exposure to both sources of exchange risk. The premium for EMU risk is mostly positive. but has decreased over the years. The non-EMU risk is consistently negative and is much larger, in absolute value, than its EMU counterpart. This suggests that the adoption of a single currency is likely to have a limited impact. European financial markets will still be exposed to the large and dominant impact of the non-EMU currency risk. In addition, the adoption of a single currency is likely to have a significant impact also on European equity markets and, in particular, on their correlation structure. For example, it is often argued that the convergence of economic structures and policies, the existence of a unique currency and identical interest rates will increase correlations and, as a consequence, reduce the benefits of portfolio diversification (see, among others, Frankel (1995)). Although our paper does not address these 1 We treat the British pound as a non-EMU source of currency risk because the United Kingdom (and Denmark) have decided to keep their option to join the EMU open through an opt-in clause. THE SINGLE CURRENCY AND EQUITY MARKETS 9 issues directly. it yields interesting insights on the way European investors are likely to adjust their portfolio holdings under the EIVIU and on the home-bias phenomenon. The rest of the paper is organized as follows. In Section 1 we briefly review some basic concepts in the theory of portfolio choice and then present a model of international asset pricing which includes both market and currency risk. In Section 2 we describe the data set. In Section 3 we present the empirical evidence. In Section 4 we discuss our results and present concluding remarks. 1 Portfolio Choice and Currency Risk Modern portfolio theory suggests that investors should hold internationally diversified portfolios to improve the reward-to-risk ratio of their asset holdings. The attractiveness of international diversification is mostly due to the low level of correlation among national markets. which has been documented in a large number of studies (see. for example. Levy and Sarnat (1970), Solnik (1974a.b, 1995), French and Poterba (1991) and Elton and Gruber (1992)). It is often argued, however, that standard mean-variance analysis does not necessarily apply when investors can allocate their wealth across assets traded in different national markets. In addition to market risk, one can think of a variety of sources of uncertainty that may be of concern to investors who are internationally diversified. For example, the risk of political turmoil in foreign countries may lead to restrictions on the repatriation of capital. Other deterrents may be differences in accounting procedures and, more generally, the costs involved in acquiring information in foreign markets. Typically, however, currency (or exchange rate) risk is the factor most commonly used to explain investors' resistance to international diversification. The return on any foreign stock fluctuates not only because of asset-specific risk. but also because of unpredictable fluctuations in the exchange rate. Loosely speaking. the latter effect is often referred to as currency risk. Although apparently obvious. this interpretation may lead to largely overstate the relevance of currency risk for several reasons. 2 First, the sources of total return volatility differ among asset classes. For example, in panel a of Table 1 we decompose the monthly return volatility of some national stock-indices as well as Eurocurrency deposits, taking the perspective of a German investor. For the stock markets in our sample the data show that at most 36.5 per cent of the total volatility is due to exchange rate fluctuations. For the European equity markets that we consider this value is even lower at 14 per cent. Panels b and c confirm this result over subsamples. Therefore, in the case of stock returns, total volatility is mostly due to fluctuations of the domestic stock market rather than to exchange rate volatility. On the other hand, the same volatility decomposition for returns on Eurocurrency deposits shows that most of the volatility is due to exchange 2 See Solnik (1996) for a thorough discussion of these issues. THE SINGLE CURRENCY AND EQUITY MARKETS 3 rate fluctuations. Second, for most developed markets, a large part of currency risk can be hedged by using derivative securities or, even more simply, by trading on foreign bond markets.3 Obviously, hedging involves a cost; but as long as exposure to currency risk can be eliminated (or significantly reduced) at a cost that is lower than the expected benefits of international diversification, investors should include foreign assets into their optimal portfolios. Third, and most important, the practical relevance of currency risk can be appropriately measured only within the context of an international asset pricing model. For example, in the domestic CAPM we know that asset-specific volatility is not a proper measure of risk, since a possibly significant part of it can be diversified when the asset is included in a portfolio. In that framework, the appropriate measure of risk-usually referred to as systematic risk-is given by the covariance of each asset return with the return on the market portfolio. In equilibrium, investors should be rewarded for their exposure to systematic risk with a premium in excess of the risk free rate. Intuition suggests that a similar idea should apply when investors can purchase assets traded in different national markets. The volatility of the return on a foreign asset (or market index) contains a country-specific component and a currency component. However. neither component should be interpreted as a measure of risk. since they can be diversified, at least in part, by including the asset in an internationally diversified portfolio. In the next section we build on this intuition to discuss an international version of the traditional CAPM which is carefully derived in Adler and Dumas (1983).