Abstract: The crisis in the ERM of the EMS in 1992 and subsequent developments threw the progress of monetary integration in Europe into confusion. The papers in this volume contribute to our understanding of the motivations behind the drive to peg currencies in the Nordic countries to the Deutsche mark, and of the problems these countries encountered in that process. An improved understanding of these motivations and problems is vital in assessing the prospects for monetary policy and exchange rate regimes for the remainder of the decade.
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Abstract: This book provides an account of the evolution of exchange rate regimes in the twentieth century.
Abstract: One key prediction of the target zone model is that the exchange rate should be mean-reverting within the band. Although this property is widely referred to in the target zone literature, little work has been done to test it. In this paper we seek to remedy this important lacuna in the literature by examining the time-series properties of the seven currencies participating in the Exchange Rate Mechanism (ERM) of the European Monetary System, for the period 13 March 1979 to 9 April 1992. Using standard univariate unit root tests we find little evidence of mean reversion. However, using variance ratio test statistics, which control for heterogeneity in the distribution of exchange rate behaviour, we find much more evidence of mean reversion. Another part of our work includes implementing a panel unit-root test. Full text available here.
Abstract: One key prediction of the target zone model is that the exchange rate should be mean-reverting within the band. In this paper we investigate this prediction by examining the time series characteristics of seven currencies participating in the Exchange Rate Mechanism (ERM) of the European Monetary System, both immediately before and after the introduction of wide exchange rate bands in 1993. Using standard univariate unit root tests we find some evidence of mean reversion, and this is much more pronounced using variance ratio test statistics. It turns out that such mean-reversion is as strong for the wide band ERM as for the narrow band ERM. Full text available here.
Abstract: This paper uses nonparametric procedures to test for a shift in the volatility of nominal and real exchange rates for members and nonmembers of the exchange rate mechanism (ERM) of the EMS. The results imply a reduction in volatility for ERM members, especially during the latter half of its operation. The authors also demonstrate that this enhanced stability was not bought at the expense of increased interest rate volatility. The issue of interest rate volatility during the British pound's participation in the ERM is also examined.
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Abstract: Why do authorities intervene intramarginally within a target zone? This paper provides an explanation by constructing a foreign exchange market with two classes of traders. One class, called fundamentalists, trade on a daily basis while the other class, called sharks, do not. Sharks enter the market only when they believe there is a high probability that the regime will crash. Their beliefs are based upon the exchange rate's position in the band. By examining the tactics available to the authority, we show that the most effective range of intervention is intramarginal, even in a regime that is ostensibly credible.
Abstract: In this paper we evaluate uncovered interest rate parity in the ERM by testing market efficiency and zero risk premia in a general asset pricing framework. The over-identifying conditions derived from the model are not rejected but we strongly reject risk neutrality. Nevertheless, estimated risk premia between ERM currencies are moderate to low. Therefore, due to the diversifiability of foreign exchange risk, the standard UIP relation between exchange rates and interest rates is a reasonable approximation within the ERM.
Abstract: This paper proposes a method to estimate separately the size of the expected depreciation in an eventual devaluation of the central parity in the ERM, and the probability assigned by agents to this devaluation occurring in the short run. The proposed method complements the information provided by the jumps observed in market exchange rates around realignments with the information contained in interest rate differentials on the future behaviour of exchange rates. The separation of probability and size allows a richer analysis of the effects of devaluations on exchange rate credibility in the ERM.
Abstract: This paper proposes an indicator of exchange rate risk for currencies subject to exchange rate regimes which are not perfectly credible. This indicator is applied to several EMS currencies for periods before and after the widening of the fluctuation bands. We find that, contrary to what standard (GARCH-type) estimates suggest, exchange rate risk within the ERM is generally lower after the band widening than before. However, exchange rate risk for currencies that left the ERM is currently higher than for ERM currencies and also higher than in the period when they belonged to the mechanism.
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Abstract: We propose a general continuous time bivariate jump-diffusion representation for the exchange rates of European currencies. Our model captures key features of the exchange rate mechanism. Fluctuation within bilateral limits is modelled by appropriate diffusion dynamics, while discontinuous variation in the level of the fluctuation band is posited to have a jump structure. Under specific assumptions, the probability distribution of the exchange rate process is derived analytically. We also perform an empirical investigation of these exchange rates. Comparing the fit of alternative models, we find some evidence of mean reversion inside the bands for these exchange rates.
Abstract: Krugman provided a rigorous economic argument for the merits of target zone exchange rate arrangements. His analysis revealed the existence of a stabilising nonlinear relation between the exchange rate and its driving fundamentals. However, the econometric testing of this relationship has proved difficult. We use data from the EMS to implement efficient testing of the Krugman model and extensions which allow mean reversion in the fundamentals process. In particular, we model the fundamentals driving the bilateral exchange rates of participating currencies by means of an Ornstein Uhlenbeck process with reflecting barriers. This specification captures the enforcement of an exchange rate fluctuation band through central bank intervention at band limits as well as through intramarginal intervention. Our empirical work is based on a period of exceptional stability in exchange rate markets and well approximates the credible band limit assumptions common in the target zone modelling literature. Building on recent work by Ricciardi and Sacerdote, de Jong, and Lindberg and Soderlind, we implement full maximum likelihood estimation of the parameters of the time series dynamics for the most heavily traded bilateral exchange rates in the EMS. In doing so, we identify the functional relation between the fundamentals and the exchange rate and quantify the nonlinearity in this relation. When nonlinearity is not present, a restriction of the model posits that the exchange rate, per se, follows a reflected OU process. A further restriction contains reflected Brownian motion as a nested special case. Our analysis affords a description of the alternative exchange rate policies adopted in the various countries party to the EMS.
Abstract: This note explores the relationship between risk and premium in foreign exchange rates. The author shows that investors in different countries demand different premiums for the same source of risk. The difference in the premiums is related only to the volatility of the source of risk and not to investor risk attitudes. The author shows how this difference is consistent with arbitrage pricing and that any contingent claim on the exchange rate has a unique price, even when the exchange rate can jump. In particular, the author resolves the seeming inconsistency reported by B. Dumas, L.P. Jennergren and B. Naslund (1993) for jump models of exchange rates.
Abstract: Exchange rate intervention by monetary authorities should defend a band not for the spot exchange rate, but for a moving average of its recent values. This target zone is soft, in that it allows greater short-run flexibility, but also rigorous: it still precludes any sustained easing of monetary policy. In comparison with conventional hard target zones for the spot exchange rate, we find considerable advantages for the rule we propose. In particular, without compromising long-run discipline, it increases resilience against speculative attacks, especially when shocks to exchange rate fundamentals are transitory.
Abstract: This paper studies the term structure of forward premia in a target zone with imperfect credibility. The relationship between spot and forward exchange rates, which reflects the possibility of realignments of the band, is studied for various intervention policies with different degrees of credibility. Forward market data is used to estimate the implied credibility of the French / German target zone during the EMS. Parameter estimates accord with the experience of the French franc / Deutsche mark exchange rate during the 1980s. Although spot exchange rates display little sensitivity to anticipated intervention, forward data can be used to detect the effects of intervention on exchange rate dynamics.
Abstract: We present a model of a 'soft' exchange rate target zone and interpret it as a stylised description of the post-August 1993 ERM. Our central bank targets a moving average of the current and past exchange rates, rather than the exchange rate's current level, thus allowing the rate to move within wide margins in the short run, but within narrow margins in the long run. For realistic parameters, soft target zones are significantly less vulnerable to speculative attacks than 'hard' target zones. These predictions are consistent with the ERM's experience and the abatement of speculative pressure in European markets since the bands' widening in 1993.
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Abstract: Macroeconomic stabilisation and forex market interventions are investigated for a small open economy with a nominal exchange rate band. In a first best situation, a band is not advisable from a stabilisation perspective, even though with money demand shocks no welfare losses are incurred. With goods demand shocks, narrowing the band effects the optimal coefficient of intramarginal monetary accommodation. With restrictions on intramarginal interventions, a band may be desirable. In particular, with supply shocks and no intramarginal interventions, a narrower band is desirable when the central bank attaches a relatively smaller weight to price, as opposed to output stability.
Abstract: We document an empirical puzzle for EMS exchange rates during a period in which the bands on these exchange rates were (almost) credible, i.e. exchange rate distributions are hump-shaped rather than U-shaped as predicted by the standard target zone model. We offer an explanation of this puzzle which is based on the combination of two realistic features, namely the presence of intramarginal interventions and wage/price sluggishness.
Abstract: The paper deals with the estimation of models for the expected rate of depreciation within the currency bands of the French franc and the Italian lira against the Deutsche mark, both unconditional and conditional upon no realignment, as well as the estimation of models for risk premia. Using these estimates, estimates are constructed for the expected rate of depreciation, the expected rate of realignment and the expected rate of devaluation of these exchange rates during the EMS period by appropriate adjustment of interest rate differentials. It is found that these adjustments are of non-trivial magnitude.
Abstract: A Monte Carlo analysis is used to compare three target zone models in reproducing some stylised facts of weekly Deutsche mark exchange rates in the EMS for the period January 1987 - August 1992. The models are the standard target zone model, a model of infra-cum-intramarginal interventions, and a model of unfulfilled realignment expectations. Compared with the corresponding dollar rates, returns on Deutsche mark rates exhibit much more non-normality, which can be generated endogenously by the latter two models, and more conditional heteroskedasticity, which can be produced simultaneously by the infra-cum-intramarginal interventions model.
Abstract: By Spring 1998 agreement must be reached on the first group of countries to participate in EMU, which is scheduled to begin on 1 January 1999. CEPR's 7th Monitoring European Integration Report argues that the final stage of transition to EMU remains poorly understood, that many extant proposals (whether from academics or policy-makers) have fatal flaws, and that finding a safer transition strategy is a matter of urgent priority. Amazingly, decisions already made at Maastricht and Madrid already preclude any certainty about conversion rates between the Euro and national currencies until EMU actually begins. Nevertheless, it would be possible to preannounce bilateral conversion rates between the 'Ins'. The authors recommend doing so immediately and on the basis of existing central parities in the ERM. They argue it would then be possible credibly to adopt very wide bands during the transition. In comparison with other proposals - such as reversion to narrow bands, or floating without prior commitment to the end point - the strategy advocated is not only more robust to speculative attack, but also more likely to deliver appropriate initial competitiveness levels in EMU. This proposal also offers a natural solution to the problem of the 'pre-Ins': their eventual entry should be at conversion rates based on central parities ruling two years prior to their entry.
Abstract: This paper develops an empirical model of exchange rates in a target zone. The distribution of exchange rate changes is conditioned on a latent jump variable where the probability and size of a jump vary over time as a function of financial and macroeconomic variables. When there is no jump, the target zone is credible and exchange rate changes are constrained to remain within the target zone band. The paper revisits 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 French Franc / Deutsche mark rate exhibits considerable nonlinearities, realignments are somewhat predictable, and the credibility of the system did not increase substantially after 1987. Moreover, our model implies that the foreign exchange risk premium becomes large during speculative crises. Full text available here.
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Abstract: This paper points to a vicious circle which may arise when a government tries to defend its currency by raising the nominal interest rate in a fixed exchange rate system. We present a stylised model in which raising the nominal interest rate helps to maintain the parity, but is costly for the government. The speculators are aware that this cost gives incentives for the government to stop defending the parity, which in turn reinforces the speculation against the currency. We show that this mechanism can generate self-fulfilling currency crises, the outcome of which depends on the level of sacrifice that the government is ready to endure and the evolution of domestic economic conditions. We provide some informal evidence showing that this model explains some features of the 1992-93 EMS crisis.
Abstract: In this paper, the pricing of currency options in a target zone model is discussed. The movement of the currency index is a product of the movement within the target zone and jumps in the target zone itself in the form or re- or devaluations. The probability of a re- or devaluation is modelled as dependent on the position of the exchange rate within the target zone. The traditional assumption of no dependence between the position of the exchange rate within the target zone and the probability of a re- or devaluation is compared with a model allowing state-dependent jumps. It is shown that the assumption of state-independent jump probabilities may lead to highly unrealistic outcomes, outcomes that will not arise if the probability of re- or devaluations is allowed to depend on the location of the exchange rate within the target zone. A comparison is made with the prices produced by the widely used Garman and Kohlhagen option pricing model.
Abstract: A time-varying stochastic devaluation risk is introduced in a model of exchange rate target zones. The model produces realistic patterns of covariation between exchange rates and interest rate differentials, which previous target zone models have been unable to do. A "drift adjustment" method to estimate devaluation expectations from data is suggested.
Abstract: Recent contributions emphasise that the presence of exchange rate target zones has important effects on the within-band behaviour of exchange rates when agents are forward-looking. We find that the implications of available models are inconsistent with European exchange rate data, and we suggest that the frequent realignments occurring in the period we consider may be responsible for this. We construct a model in which the likelihood of a realignment in the near future increases as the exchange rate approaches the limits of its fluctuations band and show that its implications are broadly consistent with the evidence.
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Abstract: Focusing on the recent experience of the EMS, the paper examines the behaviour of domestic daily returns on bond and stock markets with the objective of identifying whether there exist significant differences in the patterns of volatilities and international correlations between ERM and non-ERM countries and across alternative episodes of ERM exchange rate variability. The paper provides substantial evidence that a credible peg is associated with a decline in bond market volatility. The analysis also shows that an increase in exchange rate volatility is accompanied by a decline in international correlations between bond and, to a lesser extent, stock markets.
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Abstract: Most interpretations of the Exchange Rate Mechanism crisis of 1992/3 ignore the key role played by structural policy spillovers among European countries and overlook the effects of coordination (or lack thereof) of monetary and exchange rate policies among the countries making up the periphery of the system. This paper provides a simple analytical framework, able to encompass the recent literature on currency crises, while developing it by bringing out the decisive role of the strategic interactions among national policy-makers in a multi-country monetary and exchange rate game. In contrast to an approach that focuses exclusively on country-specific issues, a systemic view is ultimately able to unravel more coherently, and more convincingly, the "puzzles" of the ERM crisis. Also available as: CEPR Discussion Paper No. 1466, Oct 1996.
Abstract: Why was the EMS in 1992-93 swept by waves of disruptive speculative attacks? And what lessons emerged from that episode as regards to the future of the EMU?
Abstract: The recent theory of exchange rate dynamics within a target zone holds that exchange rates under a currency band are less responsive to fundamental shocks than exchange rates under a free float, provided that the intervention rules of central bank(s) are common knowledge. These results are derived after having assumed a priori that excess volatility due to rational bubbles does not occur in the foreign exchange market. In this paper, we consider instead a setup in which the existence of speculative behaviour is a datum the central bank has to deal with. We show that the defence of the target zone in the presence of bubbles is viable if the central bank accommodates speculative attacks when the latter are consistent with the survival of the target zone itself and expectations are self-fulfilling. We show that the instantaneous volatility of exchange rates within a band is not necessarily less than the volatility under free float. There need not be a constant trade-off between the volatility of the change in the exchange rate and the volatility of the change in the interest differential. Fundamental dependent bubbles can account for the excess response of the exchange rate to the fundamental. The relationship between the exchange rate and the interest differential need not be negative, even if the target zone is fully credible.
Abstract: Includes chapters on: * exchange rate systems * exchange rate arrangements between participants in the monetary union and non-participants.
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Abstract: This paper introduces two arbitrage based tests of target zone credibility using a new data source, ERM cross-rate options. Using daily option prices from September 1991 to August 1994, we assess the credibility of the pound - mark and mark - lira target zones that collapsed in September 1992, and the ongoing mark - French franc target zone. These tests are based on restrictions that must apply to all option prices within a credible target zone, and are free from specification error and estimation error. We also identify a minimum "intensity of realignment", an expression indicating the probability-weighted average realignment size.
Abstract: This paper uses data on over-the-counter options between the Deutsche mark and the pound, lira, French franc, and peseta to investigate the credibility of exchange rate target zones within the ERM. We compare empirical implications for the relation between option prices and the spot's position within the band for three classes of target zone models: those with full credibility, those with exogenous realignment risk, and those with endogenous realignment risk. Empirically, implied volatility from these options attains a maximum near the edges of an exchange rate band rather than its centre, even three to six months prior to realignment.
Abstract: Are the wide bands adopted in the summer of 1993 too large? The official answer is that wide bands offer a protection against speculative pressure, while exchange rates may be kept within narrower margins at the discretion of the authorities. Yet if exchange rate fixity and predictability are desirable, as implicitly assumed by the mere existence of the system, there must exist a trade-off between protection against speculative pressure and predictability. In that case, the bandwidth chosen should be as narrow as possible and yet unlikely to be challenged by the markets. This paper offers estimates of 'safe' bandwidths. For the long-term member currencies (French franc, peseta, Danish krone and escudo), the existing 15% bands are found to be unnecessarily wide: narrower 3.5% bands would capture at least 95% of expected exchange rate realisations over a three-month horizon. For the lira, Finnish markka and Swedish krone, wider bands of 5-6% would capture a similar amount of the exchange rate distribution. The pound's exchange rate expectations are the most dispersed, requiring 8.4% bands to capture 95% of exchange rate expectations.
Abstract: This paper uses a rich new data set of option prices on the dollar-mark, dollar-yen, and key EMS cross-rates to extract the entire risk neutral probability density function (pdf) over horizons of 1 and 3 months. We compare three alternative smoothing methods - cubic splines, an implied binomial tree (trimmed and untrimmed), and a mixture of lognormals - for transforming option data into the pdf. Despite their methodological differences, the three approaches lead to a similar pdf clearly distinct from the lognormal benchmark, and typically characterised by skewness and leptokurtosis. We then document a striking positive correlation between skewness in these pdfs and the spot rate. The stronger a currency the more expectations are skewed towards a further appreciation of that currency. We interpret this finding as a rejection that innovations in these exchange rates are independent of the level or characteristic of a credible target zone explicit or implicit. Instead, this positive correlation is consistent with target zones with endogenous realignment risk. We discuss two interpretations of our results on skewness: when a currency is stronger, the actual probability of further large appreciation is higher, or because of risk, such states are valued more highly.
Abstract: This paper presents an analysis of the sterling - Deutsche mark exchange rate prior to, during and following sterling's ERM membership. Unlike most of the empirical literature on exchange rates we take a parametric approach to modelling exchange rate dynamics based on the student's t autoregressive model with dynamic heteroskedasticity (STAR). This model, which is more general than standard ARCH-type formulations, is first postulated on the basis of the probabilistic features of the data, and then shown to provide a parsimonious and statistically adequate representation. The estimation results indicate that the statistical distribution of the sterling - Deutsche mark exchange rate is leptokurtic in all periods, and that there was a monotonic, sharp decrease in its conditional volatility during ERM membership.
Abstract: This paper explores the determinants of realignment expectations for the French franc - Deutsche mark exchange rate. Expected changes in the central parity are estimated by adjusting short-term Euromarket interest rate differentials for the expected rate of change in the exchange rate within the exchange rate mechanism fluctuation band and by the yield differential on long-term government bonds. The results indicate that the exchange rate within the band is mean reverting and that expected changes are sizeable. Realignment expectations are found to be related to the evolution of fundamental economic variables and, for shorter horizons, the position of the franc in the fluctuation band.
Abstract: This paper develops a simple optimization model to characterise the behaviour of market participants during currency attacks and tests it empirically. Specifically, we test for the determinants of the timing, magnitude and chance of success of an attack. The empirical part is carried out using Mexican data, as this market provides us with an appropriate target zone framework and with a very rich dataset. We find empirical support for a set of microeconomic determinants which include: daily order flow, inventory management, intra-day price volatility, and the forward intervention - price differential. Finally, we test for the role of central bank reserves in speculative attack dynamics.
Abstract: The behaviour of the sterling / Deutsche mark exchange rate is examined over a period from November 1988 to May 1994. At the beginning of this time period sterling did not belong to the ERM, it entered in October 1990 and was withdrawn in September 1992. In this study the effect of operating within the ERM on the volatility of the exchange rate is examined.
Abstract: We develop a parsimonious parameterization of exchange rate density functions under target zones that enables us to estimate the approximate shapes of density curves from the exchange rate data. We find that the distributions of exchange rates can take several different shapes, which may correspond to possibly widely different monetary and exchange rate intervention policies, including the marginal and intramarginal intervention policies discussed is previous theoretical models.
Abstract: The stability of the EMS depends crucially on realignment expectations of the market participants. In this paper, the authors discuss how to measure such expectations and how to relate them to economic fundamentals, central bank reputation, and institutional arrangements of the EMS. They find the following empirical regularities for French Franc / Deutsche mark and Italian lira / Deutsche mark exchange rates: expected devaluations are positively related to the current exchange rate deviation from the central parity; expected devaluations are negatively correlated to the length of time since the last realignment in the short and medium run; and the Basle-Nyborg agreements seem to have a stabilising effect for both currencies examined, albeit through different channels.
Abstract: Using reduced rank cointegration analysis, this study examines whether exchange rate realignments are effective in extenuating the deviations from PPP under the EMS. In contrast to previous studies, more positive evidence for the PPP hypothesis is found. The difference in findings can be attributed partly to the statistical technique used, the correction of the finite sample bias, and the adjustment for realignment effects. In general, the results of this study support that currency realignments of the EMS have been effective in maintaining PPP among its member countries.
Abstract: The Extended Target Zone (ETZ) proposal for economic policy coordination is quantitatively assessed and compared with a number of alternative schemes that do not adopt explicit exchange rate targeting. The main finding of the paper is that if exchange rate volatility matters, then the ETZ scheme is clearly superior to the alternatives compared here. However, an important qualification is the high degree of fiscal activism required to prevent output and inflation from deviating from target levels in order to offset the active monetary policy employed to achieve the exchange rate targets. Moreover, when this is combined with an uneven distribution of welfare gains and associated incentive compatibility problems, the ETZ scheme may become unsustainable leading to a breakdown of cooperation.
Abstract: The relation between the credibility of EMS central parities and changes in macroeconomic fundamentals is key to the economic controversy that started following the 1992 and 1993 exchange rate crises. This study provides an empirical evaluation of this link over the 1983- 1993 period. We first build a measure of devaluation expectations for the French Franc / Deutsche mark and Lira / Deutsche mark exchange rates using the so-called "drift adjustment" method in a target zone model. We then use non-stationary VAR modelling and Granger causality tests, and we compute impulse response functions to assess the role of fundamentals in the formation of devaluation expectations. Some macroeconomic variables seem to affect the credibility of the parities over the 1983- 1993 period, but the links do not generally appear to be particularly intuitive or significant from an economic point of view. Nevertheless, the effect of exogenous shocks on the credibility of the French Franc / Deutsche mark parity tends to ease off fairly quickly, while this same effect appears highly persistent in the case of the Lira / Deutsche mark parity. These results are not conclusive as regards the nature of the 1992 and 1993 exchange rate crises. However, they do suggest that the theoretical explanation for the crises in terms of multiple equilibria could be justified at least in part. This underscores the need for a more structural econometric approach. [Original paper in French.]
Abstract: Large fluctuations in the exchange rates of major currencies can be extremely costly, not only for the countries directly involved but also for the rest of the world. In this article, the authors propose a framework for international cooperation in stabilising exchange rates. Full text available in both English and in French.
Abstract: This paper explicitly incorporates exchange rate bands into the Barro-Gordon model of inflation. This is a non-trivial extension. Focusing on Markov perfect equilibria, we specify the properties of the optimal policy functions, exchange rate dynamics and hence the arguments for and against target zones. The attractiveness of alternative exchange rate regimes (i.e. fixed, flexible and target zones) and the position of exchange rates inside the band depend on the inflationary performance of the centre country.
Abstract: Contents include: * Monetary events leading up to the EMS * The mechanisms of the EMS * Performance and appraisal of the EMS * Nominal convergence * Real convergence * The EMS as a deflationary mechanism? * The EMS crisis, DM anchor and the dangers of transition * The role of the DM as the anchor currency * The official view on ERM reform * Broadening the anchor
Abstract: Although assumed to be normal, daily returns in reality are leptokurtic. Monthly returns, however, are shown to be more normally distributed. Evidence was found of dependence on consecutive daily price changes, which may be an explanation for the leptokurtosis.
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Abstract: The currency crisis model outlined in this paper assumes state-contingent reserve dynamics which depend on the deviations of the exchange rate from a misaligned central parity. The size of the misalignment is affected by an underlined fundamental which embodies money aggregates and a stochastic shock. The main result, in the presence of an irreversible switch of regime, is that the size of the attack is amplified by the feedback effect from the composite fundamental to the exchange rate.
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Abstract: This paper examines the impact that a currency target zone has on short-term interest rates. For a number of countries in the European Monetary System, we characterise the short rate using a regime-switching model that allows for a differently parameterised mean-reverting square-root process in each regime. We find that the volatility, the level, and the speed-of-adjustment are all higher in the regime that is operative during speculative attacks and currency crises. Moreover, we allow the conditional probability of being in each regime to be state-dependent so the model can be used to examine questions relating to the likelihood of realignments and the stability of the target zone system. Full text available here.
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Abstract: The models in the literature on exchange rate target zones imply a nonlinear time series model for the exchange rate. We show how the parameters of such models can be estimated and develop Maximum Likelihood and Method of Simulated Moments estimators for the target zone model of Krugman (1991). The Maximum Likelihood estimator is based on a computationally attractive approximation to the exact predictive density of the continuous time model. Monte Carlo experiments are used to assess the properties of the estimators. In the empirical part we estimate the model with data on recent EMS exchange rates. We find that the Krugman (1991) target zone model is not able to explain the full observed kurtosis and conditional heteroscedasticity of the exchange rate returns.
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Abstract: An exchange-rate system is a contract which commits central banks to intervene in the foreign-exchange market. The design features of the system include: the rules of intervention, the limits placed on exchange rates and the 'crisis scenario' describing possible transitions to new regimes. This paper considers the various trade-offs one faces in designing an exchange-rate system. One of these pertains to the amount of reserves which the central banks must have on hand in order to forestall a speculative attack and make the system sustainable. The amount of reserves needed depends crucially on the assumed crisis scenario.
Abstract: Fixed of semi-fixed exchange rate regimes have volatility paths that are, in general, less smooth than their free floating counterpart. Moreover, there tends to be a correlation between the lack of smoothness and the weakness of the currency. In this article, the effects of divergence from central parity on the smoothness of the volatility are discussed within the framework of a TGARCH model. It is shown that, for various EMS rates, the divergence indicator has a statistically significant effect on the smoothness of the volatility path.
Abstract: The purpose of this paper is to develop suitable methods for pricing of currency options under different assumptions of the nature of the exchange rate regime, with emphasis on regimes with target zone features. The analysis is facilitated by the usage of some new ideas. The first idea is to focus on the interest rate differential rather than on interest rates themselves. This approach avoids the problem with negative interest rates and reduces the complexity of the valuation formulas considerably. The second and more important idea is to take the departure from explicit models of spot and forward exchange rates without specifying interest rates exogenously. By this device, the stationary (target zone) component of the exchange rate plays an important role in that the mean reverting drift of this component will affect the price of the option. This kind of drift dependence seems to be a novelty in the option pricing literature. Finally, a modification of Merton's valuation formula for jump-diffusion processes is suggested when devaluations are introduced into the analysis.
Abstract: Consider a stochastic control problem where the state variable follows a Brownian motion. The flow reward is a function of the state, which can be regulated with a lump-sum and linear cost of adjustment. Using a discrete approximation, a simple exposition of the control problem is developed. The value matching conditions that hold for any given control parameters, and the smooth pasting conditions that hold for the optimal control are derived. Some extensions and economic applications of the method are also discussed.
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Abstract: Exchange-rate data produced by the EMS contradict important predictions made by the standard target-zone model. We show that the contradictions reflect a misinterpretation of policies pursued by the EMS countries. They intervened intramarginally, to keep exchange rates well within their bands, not at the edges of the bands, to keep rates from crossing them. In the Basle Nyborg Agreement of 1987, however, they agreed to make fuller use of the band, and exchange rates behave differently thereafter. The effect appears clearly in the behaviour of the French franc and less decisively in the behaviour of the Italian lira. We conclude by examining and rejecting other explanations for the observed difference in exchange-rate behaviour.
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Abstract: The authors examine the expected survival time of a unilateral exchange-rate target zone when constraints on monetary policy prevent the central bank from exclusively focusing on defending the target zone. Generally, the width of the target zone has a negligible effect on the expected survival time and the dominant determinants are reserve levels and the degree of real and monetary divergence between the country in question and the rest of the world. For seemingly realistic parameters, the expected survival time is fairly long: a few decades rather than a few years.
Abstract: This paper develops a model for valuing options on a currency which is maintained within a band. The starting point of our model is the well known Krugman model for exchange rate behaviour within a target zone. Results from model runs provide insight into evidence reported by other authors of mispricing of currency options by extensions of the Black-Scholes model.
Abstract: Also see 14(3), June 1995, 459-460.
Abstract: This paper extends the Krugman target zone model by including a realignment mechanism. Various properties of that realignment mechanism are discussed. The movement of the exchange rate is governed both by a Wiener process on fundamental and by a Poisson jump process with endogenous realignment size. The realignment mechanism is such that (except in cases where a speculative attack occurs) no jump in fundamental is needed to accompany the jump in the exchange rate. A risk neutral valuation of currency options is constructed. Some properties of option values under realignment risk are illustrated by numerical results.
Abstract: Discussion on previous article
Abstract: Under transactions costs, and generally any sort of friction, economic agents, acting dynamically in a stochastic environment, may find it optimal, in some region of the state space, to take no action at all. Action is triggered when the state of the economic system reaches the boundary of the 'region of no action'. In this note, first-order conditions for the choice of the region of no action, and for the type of action to be taken, are established, assuming that the uncontrolled state variable follows a diffusion process. The generic name for these conditions is 'smooth pasting' or 'high contact' conditions: they require that marginal utility should take the same value before and after the action has been taken. In this note, we show that, in some cases, these conditions involve the first derivative of the value function of the dynamic program, while, in other cases, they involve the second derivatives and require a higher form of tangency which Dumas (1988) called 'super contact'.
Abstract: * High frequency models in finance. * Detecting nonlinearities in high frequency data. * Parametric models for nonlinear financial time series. * Non-parametric models for nonlinear financial time series.
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Abstract: This paper presents an empirical analysis of central bank intervention during the 10-month period following the Louvre Accord. We first examine whether the Bank of Japan and the Federal Reserve adopted a target zone in order to stabilise the yen-dollar exchange rate, by using daily foreign exchange intervention data. We then estimate the expected future exchange rate and the expected rate of devaluation in order to verify if there was a credible target zone. On the basis of these two tests, we conclude that the central banks did adopt a target zone during the period following the Louvre Accord, but that the target zone for the yen-dollar exchange rate was not credible.
Abstract: This paper is a first attempt at evaluating the determinants of the interest rate differentials on government bonds between high yielders, namely Italy, Spain and Sweden, and Germany. In particular we concentrate on daily frequencies, where the relevance of economic fundamentals is rather limited, and address the question of the relative importance of local and global factors in the determination of such spreads. We identify and measure three components of total yield differentials: one due to expectations of exchange rate depreciation, which we call the exchange rate factor; another which reflects the market assessment of default risk; and a last one due to the different taxation treatment of long-term yields. We propose and discuss alternative measures of the exchange rate factor and of the default risk premium and favour those based on interest rates swaps. Overall our investigation provides strong evidence in favour of the existence of a common trend for the Italian and Spanish spreads on Bunds, which is not shared by the Swedish spread. Such a trend is driven by international factors and is independent from country-specific shocks. Country-specific shocks are only relevant in explaining short-term cycles around the common stochastic trend.
Abstract: This paper proposes a procedure, based on nearest-neighbour predictors, for testing the existence of nonlinear forecastable dependencies in time series. An empirical application to EMS exchange rates illustrates the performance of the test. Full text available here.
Abstract: In this paper we extend nearest neighbour predictors to allow for information content in a wider set of simultaneous time series. We apply these simultaneous nearest neighbour (SNN) predictors to nine EMS currencies, using daily data for the 1st January 1978 - 31st December 1994 period. When forecasting performance is measured by Theil's U statistic, the (nonlinear) SNN predictors perform marginally better than both a random walk and the traditional (linear) ARIMA predictors. Furthermore, the SNN predictors outperform the random walk and the ARIMA models when producing directional forecasts. When formally testing for forecast accuracy, in most of the cases the SNN predictor outperforms the random walk at the 1% significance level, while outperforming the ARIMA model in three of the nine cases. On the other hand, our results suggest that the probability of correctly predicting the sign of change is higher for the SNN predictions than the ARIMA case.
Abstract: In this paper, we consider a multilateral target zone model that generalises Krugman's model of a bilateral target zone. Parities are defended by manipulating money supplies in participating countries. This means that interventions aimed at one given exchange rate influence other exchange rates as well. As a result of these "externalities" shocks on each fundamental affect the whole range of exchange rates involved. Moreover, intramarginal interventions arise endogenously, and the exchange rate distribution does not exhibit the u-shaped pattern which is typical of traditional target zones. Instead, our model gives rise to "intramarginal targets" to which exchange rates tend to return. The location of these targets is shown to depend on the intervention/sterilisation mix adopted by monetary authorities. Full text available here.
Abstract: Fixed exchange rates are less volatile than floating rates. But the volatility of macroeconomic variables such as money and output does not change very much across exchange rate regimes. This suggests that exchange rate models based only on macroeconomic fundamentals are unlikely to be very successful. It also suggests that there is no clear tradeoff between reduced exchange rate volatility and macroeconomic stability. (originally LSE Financial Markets Group Discussion Paper No. 163, 1993)
Abstract: In this paper we develop a rational expectations exchange rate model which is capable of confronting explicitly agents' beliefs about a future switch in exogenous driving processes. In our set-up the agents know with certainty both the initial exogenous process and the new process to be adopted when the switch occurs. However, they do not know with certainty the timing of the future switch as it depends on the path followed by the (stochastic) exchange rate. The model is discussed in terms of the British return to pre-war parity, in 1925. However, our results are applicable to a variety of situations where process switching depends on the motion of a key endogenous variable.
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Abstract: In the context of a flexible-price monetary exchange rate model and the assumption of uncovered interest parity, we obtain a measure of the fundamental determinant of exchange rates. Daily data for the EMS is used to explore the importance of nonlinearities in the relationship between the exchange rates and fundamentals. Many implications of existing "target-zone" exchange rate models are tested; little support is found for existing nonlinear models of limited exchange rate flexibility.
Abstract: Several authors have postulated econometric models for exchange rates restricted to lie within known target zones. However, it is not uncommon to observe exchange rate data with known limits that are not fully 'credible'; that is, where some of the observations fall outside the stated range. An empirical model for exchange rates in a soft target zone where there is a controlled probability of the observed rates exceeding the stated limits is developed in this paper. A Bayesian approach is used to analyse the model, which is then demonstrated on Deutsche mark / French franc and ECU / French franc exchange rate data. Full text available here.
Abstract: The issue of credibility and capital mobility in the EMS is re-examined using an alternative methodology, as well as a longer sample period than previous studies. In particular, the dynamic relationship between interest rate differentials and the exchange rate risk premium is emphasised. The relationship between the premium and credibility is then used in order to identify patterns of credibility in ERM countries. Credibility in the case of Italy has declined post-1985, as indicated by the rising exchange rate risk premium. For Denmark, France and Ireland, credibility seems to be increasing up to the currency crisis period and for Belgium and Holland credibility increased early in the period and remained high during the rest of the period.
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Abstract: Some have concluded that the foreign exchange market is not working well. The conclusion is fed by recent developments in international financial markets, on the one hand, and by a number of academic findings on the other. I review the grounds for these concerns and then review various proposals that have been made for improving the system
Abstract: A book in 4 sections covering topics such as policy coordination, exchange rate issues (EMS, EMU, German unification), rate determination, markets and reserves.
Abstract: This paper identifies key issues surrounding the advisability and practicality of adopting target zones for the exchange rates of major currencies.
Abstract: When central banks are about to relinquish control over their exchange rate and enter into a currency union, the reputational costs to devaluation are very low. As with any finite-horizon game, the endpoint affects the earlier expectations of private agents, here causing them to demand higher interest rates and higher wages from countries whose currencies are relatively weak. In looking at the countries within the EMS, we find that Italian long-term interest rates as well as price and wage levels relative to Germany show evidence of growing gaps. We also find that the real appreciation of the lira appears to be predominantly due to increases in relative Italian government spending, and not to relatively rapid Italian productivity growth. Taken together, this evidence suggests that convergence within the EMS may have peeked. Furthermore, moving forward the date of currency union may in the short run increase both the growth of the gaps and the need for exchange rate realignment.
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Abstract: Simple techniques of regulated Brownian motion are used to analyse the behaviour of the exchange rate when official policy reaction functions are subject to future stochastic changes. We examine exchange rate dynamics in cases where the authorities promise (i) to confine a floating rate within a predetermined range, (ii) to peg the currency once it reaches a predetermined future level, and (iii) to unify a system of dual exchange rates. Similarities among these and several related examples of regime switching are stressed. We also discuss how stochastic regime changes can affect some standard statistical tests of hypotheses about exchange rates.
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Abstract: In this paper we have set out to extend the work on convergence from its conventional focus on convergence between the first moments of stochastic series to investigate the convergence of second moments using a new test for common features. We find very strong evidence that the volatility of the sterling and the Deutsche mark against the dollar is driven by a common underlying process, or feature. In contrast to this, the cross rate between sterling and the Deutsche mark has nothing in common with the bilateral rates with respect to the dollar. This suggests that convergence in second moments may be taking place more rapidly than convergence in first moments and that the underlying shocks affecting the European currency markets may have more in common than one might suppose by looking at the movements in the level of exchange rates.