The contagious impact of the European sovereign debt crisis on the foreign exchange market

1. Introduction

In 2010, the debt crisis caused the euro to go down 10% in a three-month period. Some largest hedge funds in America discovered this opportunity and short euro in groups to an enormous scale. Later on, the British pound is being infected. It continuously dropped for six days, which wrote the longest dropping period record. In this paper, the objective is to critically analyse how the European sovereign debt crisis affects foreign exchange markets. The theme focuses on the contagion on the markets. The contagion phenomenon exists between foreign exchange spot and derivative markets. One of the channels is the investor sentiment, which makes large scale of influences on both markets and volatility dynamics (Corredor, P., Ferrer, E., Santamaria, R., 2015). It makes sense on aspects like trading volume, effective transaction costs and so on.

This paper has two main parts. The first part is to evaluate impacts on foreign exchange spot market through analysing the political channel, bank channel and financial markert channel. The second part is to investigate impacts on foreign exchange derivatives, especially on the foreign exchange swap.

2. Contagious impact on the foreign exchange market

2-1 Impacts on foreign exchange spot (impacts on euro)

In this part, we explain how the debt crisis makes impacts on the foreign exchange spot market, especially, we focus on the exchange rate of euro against dollar. In FX spot market, two parties sign a contract to exchange different currencies on the spot date. The exchange rate where the transaction is done is named the spot exchange rate (David W. Blackwell et al, 2007). The effects of the debt crisis can be caused by political, bank and the financial market channel.

Figure 1 The exchange rate of euro