The European Single Currency and World Equity Markets
GIORGIO DE SANTIS, BRUNO GERARD AND PIERRE HILLION
The 1991 Treaty on European Union (Maastricht Treaty) set 1 January 1999 as the starting date for the final stage in the creation of the European Monetary Union (EMU). As of I January 1999, the exchange rates between EMU participants will be irrevocably fixed to start the transition towards a unique currency, the euro, which is expected to become the legal tender for EMU participants by the year 2002.
Most advocates of 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 favour 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 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. Secondly, 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 towards non-EMU currencies such as the US dollar, the Japanese yen and the British pound.1 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 analyse 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 aggreg-
We thank the Bank for International Settlements in Basle for graciously providing some of the Eurocurrency deposit data and CIBEAR-USC for research support.