The ecu is based on a basket of EMS member currencies, and its structure may be determined either by calculating the member currencies' relative shares from given target values or by starting with target values for the currency shares and then determining the amounts of the various currencies that are required to attain them.

The prevalent `official' view is that the ecu's structure should reflect the relative economic strength of the member countries as closely as possible, in order to serve as a `natural hedge for Europe', so their relative shares must remain constant. Given the present systematic inflation differentials, this requires regular adjustments of the currency amounts, to prevent the weights of the weaker (stronger) currencies from declining to zero (approaching unity). The ecu basket had to be extended in any case whenever new members joined the EMS. Others argue in favour of keeping the absolute currency amounts constant while allowing the currency shares to fluctuate in line with parity changes between EMS member countries, on the grounds that ecu basket adjustments typically disrupt private ecu markets with a substantial lead and that the prices of ecu-denominated assets are biased in periods of impending basket adjustments.

In Discussion Paper No. 445, Research Fellow Martin Klein and Sigrid M Müller view the ecu as a simple derivative asset and apply the techniques of arbitrage pricing theory to investigate both the structure of the ecu and the interaction between the official and the private ecus, focusing on the case of time- dependent (but not state-dependent) basket readjustments. Klein and Müller first derive a general arbitrage pricing relationship, which holds during periods of impending ecu basket adjustment and second show that basket readjustment rules of type used in practice do indeed introduce an upward bias in ecu interest rates, which is increased by uncertainty about the timing of basket adjustments.

Their results favour unambiguously the view that the amounts of currencies in the ecu basket should be held constant by allowing fluctuations and shifts in their relative shares. The relative composition of the ecu would then gradually shift toward the low-inflation countries, effectively crowding out the high-inflation countries, so it would effectively serve as a `platform' for intra-EMS currency competition.

Ecu Interest Rates and Ecu Basket Adjustments: An Arbitrage Pricing Approach
Martin Klein and Sigrid M Müller

Discussion Paper No. 445, September 1990 (IM)