Target Zones and Exchange Rates: An Empirical InvestigationIn this paper we develop an empirical model of exchange rates in a target zone. The model is general enough to nest most theoretical and empirical models in the existing literature. We find evidence of two types of jumps in exchange rates. Realignment jumps are those that are associated with the periodic realignments of the target zone and within-the-band jumps are those that can be accommodated within the current target zone. The exchange rate may jump outside the current target zone band, in the case of a realignment, but when no jump occurs the target zone is credible (there is zero probability of a realignment) and the exchange rate must stay within the band. We incorporate jumps, in general, by conditioning the distribution of exchange rate changes on a jump variable where the probability and size of a jump vary over time as a function of financial and macroeconomic variables. With this more general model, we revisit the empirical evidence from the European Monetary System regarding the conditional distribution of exchange rate changes, the credibility of the system, and the size of the foreign exchange risk premia. In contrast to some previous findings, we conclude that the FF/DM rate exhibits considerable non-linearities, realignments are predictable and the credibility of the system did not increase after 1987. Moreover, our model implies that the foreign exchange risk premium becomes large during speculative crises. A comparison with the Deutschemark/Dollar rate suggests that an explicit target zone does have a noticeable effect on the time-series behavior of exchange rates. |
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23 July 23 March 749 observations band bilateral rate Bundesbank capital controls central bank conditional distribution conditional mean conditional on available conditional variance conditional volatility consists of weekly credible target zone cumulative inflation differential currency crises data set consists devaluation distribution of exchange econometric estimates European Monetary System exchange rate changes exchange rate movements exchange rate target FF/DM rate FF/DM target zone floating currencies floating exchange rates foreign currency reserves foreign exchange risk French Franc French Franc/Deutschemark FF/DM interest differential interest rate differential Interest Rate Parity Jorion Journal of International jump probability jump risk Krugman model level of reserves lines indicate realignments Maastricht Treaty mean reversion model of exchange NBER Working Papers non-linear normal distribution observations from 23 out-of-sample parameters position predict premia realignment jumps realignment probabilities risk premium Rose and Svensson slope speculative attacks target zone models total of 749 truncated normal UIRP weekly observations within-the-band jumps yield curve zone band