Volatility and the Euro: an Irish perspective

Abstract

With Ireland joining the Euro, exchange rate risk between participating states is gone. However, as is known, this new currency will continue to face exchange rate risk, and the general reduction of volatility on a day to day basis for Irish economic agents neglects to take account of possible extreme problems with the Euro. In this paper we will see that even though the Euro is a managed (irrevocably fixed) system, trade between Ireland and non-members, most notably the US, involves two separate currencies. This trade will require currency trading, leading to the possibility of large downside exposure to exchange rate risk for Irish exporters. In order to determine the extent to which the currencies can fluctuate, this paper examines exchange rate volatility using an Extreme Value approach. A number of different volatility scenarios are offered based on extrapolation of different exchange rate regimes under two broad headings, floating and managed. Using these headings, a number of actual systems are analysed including the ERM, the Snake in the Tunnel and Bretton Woods.