A nice empirical application exercise of augmenting the interest parity approach to try to determine what is driving changes in expected exchange rates that then affect the current spot rate. Here, the authors emphasize sovereign risk, that is, risk that some euro governments might default and that the euro as a currency might not survive.
We identify the drivers of the movements in the euro-dollar exchange rate during the sovereign debt crisis. In particular, we show that the announcement of outright monetary transactions (OMT) by the Governing Council of the ECB during the summer of 2012 played a major role in the euro’s subsequent appreciation. OMT and the reform efforts undertaken by governments at national and European level saw off the risk of a euro-area break up and prompted net capital inflows. We estimate two models. The first is a reduced form high-frequency model, in which the exchange rate is explained by the differentials between interest rates in euros and dollars at both short- and long-term horizons, the sovereign spread in euro-area countries and an index of volatility. The second is a vector autoregressive (VAR) model including GDP growth differentials, short-term nominal interest rate differentials and inflation differentials between the euro area and the U.S., an average of the sovereign spreads of selected euro-area countries, the bilateral trade balance and the euro-dollar nominal exchange rate. Both approaches suggest that the evolution of the sovereign spread supported the value of the euro following the announcement of OMT in the summer of 2012.