ERM effects on currency spot and futures markets

The effects of the Exchange Rate Mechanism (ERM) of 1991-1993 on currency markets are examined. It is shown that the mechanism has led to a regime shift going from the 1980s to the 1990s. The floating exchange rates of the 1980s are associated with the forward premium puzzle (FPP) in spot markets. Furthermore, the futures-spot basis does have explanatory power on futures returns, which violates the expectations hypothesis. In the 1990s the FPP is diminished and uncovered interest parity holds in spot markets and futures returns cannot be explained by the basis. Therefore, the main contribution of this article is that the ERM has reduced currency risk premium volatility and thus validated the expectations hypothesis in both spot and futures markets.