Assessing The Threat Of Major Exchange Rate Realignments

The collapse of fixed and managed exchange rate systems around the world and the resulting exchange rate instability has been one of the major events of the 1990s. The devaluation of the British pound and the Italian lira in 1992, the Mexican devaluation of 1994 and the series of East Asian devaluations since last year have increased the need for a better understanding of the behaviour of exchange rates and the sources of exchange rate realignment risk. Research by José Campa and Kevin Chang published in the latest issue of the Economic Journal addresses this need, providing important new insights into the advance indicators of future exchange rate realignments.

Campa and Chang''s research takes advantage of the growing use of financial derivatives in most currency markets to extract information that will help our understanding of such exchange rate risk. For example, the researchers use data on over-the-counter options between the mark and the pound, lira, French franc, and peseta to investigate the credibility of the ERM exchange rate target zones.

Empirically, they observe that the implied volatility from these options increases as the value of the underlying exchange rate approaches the edges of its exchange rate band. This increase in implied volatility is a clear signal of the financial markets'' perception that a period of large movements in the exchange rate – a devaluation or a realignment of the currency within the existing band – is more likely to occur when the exchange rate is close to the edge of its existing band. The researchers find this effect to be very persistent and to exist even three to six months prior to any realignment.

Campa and Chang also develop an easy measure of intensity of realignment, which measures the probability times the size of a possible realignment that can be inferred from option prices in these currencies and that can be used for the management of devaluation risk. They estimate this measure for a number of currencies and find, for example, that in the spring and summer of 1992, the financial markets expected a minimum intensity of realignment for the lira/mark exchange rate over the next six months that was as high as 4.5%, consistent with a 0.45 probability of a 10% devaluation.

Of course, the lira devalued in September of that year and the measure, computed with information available up to six months prior to the actual devaluation, provided strong signals for such devaluation. This effect is not unique to the lira, and the research shows that there were similarly positive realignment intensities for the British pound and the Spanish peseta prior to their devaluations relative to the German mark as well as for other non-ERM currencies, such as the Brazilian real prior to its devaluation relative to the US dollar during 1996 and 1997, and for the Czech Krone during the period in 1997 that it was tied to a basket of US dollars and German marks.

The next step in the research identifies what economic fundamentals are causing the changes in these devaluation intensities. The researchers use a number of macroeconomic fundamentals suggested in the existing literature as drivers of the probability of a currency''s devaluation and correlate them with their estimates of devaluation intensities for the European currencies. The analysis provides evidence that a real appreciation of the domestic currency and a decrease in the level of foreign currency reserves of the country tend to increase the intensity of realignment of the country''s currency.

''ERM Realignment Risk and its Economic Determinants as Reflected in Cross-rate Options'' by José Campa and P.H. Kevin Chang is published in the July 1998 issue of the Economic Journal. Campa is at New York University''s Stern School of Business, 44 West 4th Street, New York, NY 10012; Chang is at the University of Southern California''s School of Business Administration (Finance Dept), Los Angeles, CA 90089-1421.