Abstract: In the endgame of a fixed exchange rate regime, increases in interest rates to defend the currency may lead to an apparently perverse market response: further downward pressure on the exchange rate. This may result if a large proportion of investors' foreign exchange exposure is dynamically hedged. This paper describes the trading operations involved in implementing dynamic hedges and the impact of these operations on central bank policy. The success of an interest rate defence hinges on the size and timing of the funding operations of those who are being squeezed relative to those engaged in dynamic hedging.
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Abstract: The authors incorporate a Bayesian learning model into a fairly general model of exchange rate determination in discrete time. The model is applied to the period following the widening of the French - German ERM bands in August 1993, in which a systematic underprediction of the franc can be observed until February 1994. A (substantial) part of these forecast errors can be mimicked by a Bayesian learning process. Simulations with our model show that, after the widening of the bands, agents, contrary to their initial expectations, gradually learned that the true process driving monetary conditions in France had not changed notably.
Abstract: One cost involved in going from an adjustable peg exchange rate regime to a system of irrevocably fixed exchange rates, by the introduction of a single currency, is that the participating members will forego the option to realign that is inherent in any adjustable peg system. This issue is of relevance in Europe, where the introduction of a European Monetary Union and a single currency is actively contemplated. This paper values the option to realign using recently developed methods of optimal regulation of Brownian motion, as exposited by Dixit.
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Abstract: A collection of essays written between 1985 and 1992 by Giovannini on this topic.
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Abstract: Recent breakthroughs in the theory of exchange rate target zones have not been followed by similar contributions on the empirical side. The drift adjustment method of evaluating the credibility of a target zone has become common practise. However, the estimates of the expected rate of depreciation inside the band do not model knowledge of the band in the agents' information set. In this paper, a rational expectations limited-dependent variable method to estimate the expected rate of depreciation is used to remedy this weakness. In the case of the French franc - Deutsche mark target zone with daily data covering a 4 year period, we show that expected rates of devaluation of the order of 25% were still present in the early 1990s.
Abstract: This paper proposes a new credibility indicator for the EMS based on the realignment expectations calculated using the inferred probabilities derived from the estimation of a Markov-switching regimes model. This indicator avoids most of the problems presented by the so-called `drift adjusted method' and, in particular, it accounts, in a natural manner, for `ex-ante' expectations instead of using `ex-post' realignment times in order to deal with the jumps in the exchange rates. The periods of high probability of realignment match very closely the crisis of the EMS.
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Abstract: This book contains a collection of chapters discussing the issues involved in establishing a stable global exchange rate system. In doing so, the authors review the advantages and disadvantages of the various exchange rate regimes use throughout the world during the last fifty years, analyze the role of exchange rate systems in recent international financial crises and explore the probability of constructing a stable global arrangement in the next century.
Abstract: It is widely held that capital controls are necessary to prevent foreign exchange market crises in a fixed-but-adjustable exchange rate system like the EMS. Is was therefore argued that capital market liberalisation, which came in July 1990, might lead to recurrent crises in the EMS. Events since July 1990 have shown that capital controls were not necessary for the stability of the EMS. This paper shows that even with capital controls the system might enter turbulent periods and might experience a self-fulfilling balance of payments crisis if the authorities are perceived to dislike high domestic interest rates. A crisis can then be triggered by any small shock if the authorities are not willing to raise domestic interest rates sufficiently to defend the exchange rate.
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Abstract: This paper examines the credibility of the exchange rate policy pursued by the Belgian monetary authorities of pegging the Belgian franc to a narrow fluctuation band around the Deutsche mark, in the context of the ERM of the EMS. Simple interest rates corridor analysis, based on the Belgian-German long term interest rate differential and taking explicit account of the currency's position within its fluctuation band, appears to suggest that the hypothesis that long run exchange rate credibility has been attained should be rejected, even though considerable progress has been made in this regard since the early 1980s. The paper proceeds to decompose the Belgian-German interest rate differential into a sovereign credit risk and an exchange rate risk component, by modelling inflationary expectations, and concludes that long run exchange rate credibility cannot be rejected from 1990 onward.
Abstract: This paper builds on work which modelled the sterling effective exchange rate as a structural equation making explicit allowance for the forward looking nature of the foreign exchange markets. The approach was based on the assumption of rationality on the part of the agents and the estimation was carried out on the basis of the full REH assumption. This paper extends this line of research in two main ways: for the first time, the model is applied to a bilateral exchange rate rather than an effective rate, and the full learning model is then incorporated as part of a complete large macroeconometric model which then allows the analysis of a range of important questions under the assumption of model consistent learning on the part of agents. This takes the form of examining two types of entry into an exchange rate mechanism. The first advocates joining an exchange rate regime at the sterling - Deutsche mark rate prevailing at the time, the second entering by announcing a target exchange rate which is higher than is currently the case. The introduction of model consistent learning to a large empirical model is an important innovation which can give quite different model properties from either ignoring expectations effects or the dramatically oversimplified assumption of rational expectations.
Abstract: Most empirical studies fail to detect any systematic effects of the EMS regime on the economic performance of member countries. This reveals the difficulty of constructing controlled experiments that can distinguish what is due to the EMS from that due to common external pressures. The authors argue that the crucial step is to examine the exchange rates' distribution, since no performance improvements will appear if exchange rate behaviour does not change within the EMS. They find that there are changes in the third and fourth moments which imply that EMS currencies have become more fragile and susceptible to shocks (particularly negative shocks) relative to non-EMS currencies.
Abstract: This paper attempts to detect any changes in exchange risk as measured by the conditional variance of exchange rate changes before and after foundation of the EMS. The analysis is based on estimation of an econometric model in which the conditional variance is allowed to follow an autoregressive pattern. The results indicate a significant decrease in the volatility of the conditional variance and the risk premium for the EMS countries over the EMS period. No such changes are detected for the non-EMS countries.
Abstract: The aim of this paper is twofold: First, it shows that: (a) sufficient conditions for unit roots, found in AR systems, to persist in VAR systems amount to Granger non-causality in any direction among the variables involved. This implies that a necessary condition for the disappearance of one unit root in a VAR system implies Granger causality in at least one direction; (b) for first-order models with non-explosive variables, Granger causality is also sufficient for cointegration; and (c) causality and cointegration inference are strongly affected by the omission of an important causing variable. Second, our new analytical framework allows us to formulate and test several new variations of the so called German Dominance Hypothesis, in a unified cointegrating framework, which we define as Strong, Semi-Strong and Weak (types 1 and 2) German Dominance. In addition, we allow for the possibility that the dominant player may lie outside the EMS, so that we introduce and test the `US Dominance Hypothesis'.
Abstract: Previous empirical evidence indicates that uncovered interest parity (UIP) does not hold for target zone exchange rates, like those in the European Monetary System and in the Nordic countries. We explore a target zone model where the market infers the probability of a realignment of the band on the basis of a noisy signal. We show theoretically and through Monte Carlo simulations that if the market overrates the information content in the signal, then this may explain the empirical results obtained from testing UIP for target zone exchange rates.
Abstract: A model that includes bounded price variation and rational expectations by producers is estimated for the US corn market. The resulting model specification is highly nonlinear though since the probability of market equilibrium must be determined endogenously. Unlike previous research, the cross-equation restrictions implied by the rational expectations hypothesis are incorporated in the bounded prices model by using Fair and Taylor's (1983) procedure for obtaining maximum likelihood estimates of nonlinear rational expectations models. The resulting model is compared against a standard equilibrium model with naive expectations. The results show the bounded prices model is a superior specification.
Abstract: It is not enough to look at the distance of a currency from its intervention limits against the Deutsche mark to determine whether or not it is close to the edge of the EMS band. In practise, currencies often come up against the limit with another currency before reaching the limit against the Deutsche mark. We show that, taking account of multilateral obligations, most currencies did not spend a disproportionate amount of time near the middle of the available fluctuation band - especially before 1987.
Abstract: The present study examines the performance of a number of alternative GARCH / EGARCH models in the pre- and post- EMS periods. Our empirical results render support for EGARCH specifications in modelling bilateral exchange rates. The fact that EGARCH models are able to characterise the behaviour of EMS rates is consistent with the unique features of the EMS as a managed-float regime. The existence of a band for EMS rates calls for interventions from the central banks whenever a particular pair of rates moves outside the band as a result of a large shock, or successive shocks in the same direction. The EGARCH model, with its ability to model the magnitude as well as the direction of shocks, is particularly relevant for capturing the temporal relationships between shocks in currency movement and future conditional volatility. In addition, we also find that the EMS arrangements are quite effective in reducing the conditional and unconditional volatility in the currency market.
Abstract: In a small open economy with fixed exchange rates, standard theory suggests that domestic inflation and interest rates should equal those abroad. In a credible target zone, the same theories suggest that inflation and interest rates should be 'close'. Here, we seek to make precise this idea of limits on inflation and interest rate differentials consistent with limits on exchange rate movements. We then examine the case of Ireland, which joined the Exchange Rate Mechanism (ERM) of the EMS in 1979 attracted by the prospects of lower, German influenced, inflation and interest rates. We find in the early years of the ERM, both Irish inflation and interest rates were inconsistent with credibility of the exchange rate regime; in the latter years, from 1987 on, rates were in the derived range around German rates.
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Abstract: The target zone exchange rate literature, initiated by Krugman, has relevance for the question of what is the optimal level of reserves. In particular, Krugman and Rotemberg show that there is a well defined boundary between a target zone that is subject to speculative attack and one which is sustainable. This boundary is defined by whether reserves are sufficient or not. This paper reviews briefly both the target zone and speculative attack literature. The appropriate level of reserves for Ireland is then calculated and discussed.
Abstract: Placing limits on the movement of economic fundamentals in order to maintain an exchange rate within a target zone also puts a target zone around interest rate differentials. The bandwidth of exchange rate and interest rate differentials target zones will be different except at one point; it is suggested that this point gives a useful partitioning of target zones into broad and narrow categories. For realistic parameter values, this occurs at an exchange rate target zone of plus or minus 3.2%. Full text available here.
Abstract: We estimate a target zone model for three ERM exchange rates for 1983-6 and 1987-91 by the method of simulated moments, taking account of the continuous time specification by using daily data with the interruptions of holidays and weekends. Specification tests are unable to reject the model. The estimates imply, however, an essentially linear relationship between the exchange rate and the fundamentals, with a very limited 'honeymoon effect'. Using Monte Carlo simulations, calibrated on the estimates, we find that standard tests for mean reversion of the exchange rate would largely reject the target zone model when, in fact, it held.
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Abstract: Using a monetary model of exchange rate determination, we study exchange rate dynamics with bubbles which depend on stochastic market fundamentals. These dynamics can be either stochastically stable or unstable; and either monotonic or non-monotonic (including cyclic). In an extreme case, they converge with probability one and exhibit cyclic movements. Implications for the analysis of time-dependent regime shifts are also explored. Exchange rates with bubbles are likely to appear less volatile than the fundamentals in finite samples. Both the variance bounds and cointegration tests might thus be ineffective in testing the absence of bubbles under fundamentals uncertainty.
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Abstract: This paper studies the respective roles of the fundamentals and self-fulfilling speculation in currency crises. We first present a model of a fixed exchange rate system in which self-fulfilling speculation can arise following a bifurcation in the fundamentals. We then estimate the model in the case of the 1992-3 crisis of the French franc, and find some evidence that self-fulfilling speculation was at work.
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Abstract: Contents include: * The EMS crisis and the French franc * Spain and the real exchange rate problem * What coherent strategy is there for the escudo? * The Irish pound and the ERM * Italy in the EMS: after crisis, salvation ? * The UK and the ERM * On widening the EMS to central and Eastern Europe * The determinants of realignment expectations under the EMS * Towards monetary union in Europe * How to save the EMS * A rethink for the ecu? * Determinants of long term interest rates in selected countries *The need for real convergence in a monetary union
Abstract: This paper proposes an arbitrage free trilateral target zone model of a credible target zone regime with its bands on each bilateral exchange rate. The no arbitrage condition reduces the system to only two dimensions. Any two rates must obey their own boundaries but, in addition, the free rein for movements is restricted by the band of the redundant rate. Therefore, target zone models defined in bilateral settings do not apply to general systems with a cobweb of bilateral bands, such as the European Monetary System (EMS). Since the model has no known analytical solution it is estimated by the method of simulated moments.
Abstract: The objectives of this study are to model the behaviour of exchange rates under target zones, where there are upper and lower bounds on bilateral exchange rates. Theoretical frameworks of Flood, Rose and Mathieson, and Krugman are used. Long-run relationships for unit root nonstationary bilateral exchange rates of three currencies (Belgian franc, French franc and Italian lira) against the German mark are estimated. A suitable error correction model is used to obtain a specific parametric form for predicting exchange rates during the post sample period. It is shown that our equations have smaller predictive errors than random walk models.
Abstract: The theory of exchange rate target zones focuses on the role of exchange rate expectations in determining exchange rate behaviour and interest rate differentials in currency bands. This paper analyses earlier models of the target zone research programme as well as more recent developments including endogenous realignment expectations, price rigidities and alternative monetary feedback rules by means of a unified approach. Target zones may be the cause of stabilising or destabilising exchange rate expectations, the determinants of which crucially depend on the within-band central bank policy as well as the credibility of the central banks commitment to defend the target zone. The paper closes with a discussion of the relative merits of implementing a target zone and some suggestions for further research.
Abstract: This paper presents a target zone model with imperfect asset substitutability in which exchange rates are driven both by expectations regarding the credible defence of the currency band and foreign exchange traders' stop-loss trading strategies. The model generates excess volatility and non-uniqueness in the density function of the exchange rate. These results obtain independently of whether the stop-loss strategies are known to the market. In an empirical section, the authors find support for the existence of excess volatility for selected countries of the EMS during the stable EMS period.
Abstract: This paper applies the analytical approximation technique of collocation to the stochastic sticky-price exchange rate target zone model. The technique can be used to trace out the resulting nonlinear exchange rate path with remarkable accuracy while requiring comparatively little computational effort.
Abstract: The term structure of interest rates in a sticky price target zone model with perfectly credible marginal central bank intervention is identified by means of an arbitrage-free valuation. We find that an explicit credible target zone for the exchange rate is associated with an implicit target zone for the long-term interest rate where the nonlinearity of the exchange rate function translates into a corresponding stabilising nonlinearity of the long-term interest rate. Imposing a target zone reduces the variability of short-term and long-term interest rates and induces a steeper term structure relative to freely floating exchange rates. Full text available here.
Abstract: Ten papers from a conference organised by the Bank of Italy in July 1992.
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Abstract: In this paper, possible interest rate linkages between the US ad Europe and within Europe are investigated with special reference to the EMS. We use 3 month domestic money market rates from 1974 to 1979, from 1983 to 1989, and from 1990 to 1994 for Belgium, France, Germany, Italy, the Netherlands, Switzerland, the UK, and the US. For all periods, we find a strong German influence on the development in the other European countries and, for the first two periods, at best a very weak direct influence from the US. However, Germany does not dominate the other countries totally. There are significant relations between the EMS member countries which are not influenced by Germany, and there are relations to other EMS members than Germany from outside this system.
Abstract: The paper analyses the sources of persistent interest rate differentials vis-a-vis Germany that have existed in Belgium, Denmark, France, Ireland, Italy, and the Netherlands. In a target zone system like the ERM, interest rate differentials mainly reflect devaluation expectations, which are measured here by raw 1-month Euromarket interest rate differentials, drift-adjusted 1-month differentials, and differentials in long-term government bond yields. The role of a large set of fundamental macroeconomic variables that may have affected these devaluation expectations is investigated within a vector autoregressive (VAR) setting, by means of Granger-causality tests, impulse-response functions and variance decompositions. We find no evidence that fundamentals are more relevant to drift-adjusted devaluation risk than for unadjusted interest rate differentials. A significant impact of inflation, budget deficits, and unemployment becomes evident for almost all ERM-participants.
Abstract: This paper provides a framework for evaluating how market participants' beliefs about foreign exchange target zones change as they learn about central bank intervention policy. We generalise the standard target-zone model to allow for intramarginal intervention. Intramarginal intervention implies that market participants' beliefs about the target zone can be determined from their beliefs about the likelihood of intervention. We then estimate a daily probability of intervention model for the period following the Louvre Accord. We find that the market's views of intervention target zones would have varied quite a bit over time even over this relatively stable period.
Abstract: This paper applies techniques of regulated Brownian motion to a model of a small open economy to investigate how bands on fundamental driving variables affect the realisation of the nominal exchange rate, the real exchange rate, prices and output. We show that these bands mitigate the relationship between exogenous fundamentals and endogenous variables through their effects on expectations. We also consider the effects of changing the width of the band and find greater stabilisation of endogenous variables with more narrow bands on exogenous fundamentals.
Abstract: In this paper, we demonstrate how an infinitesimal unsterilised foreign exchange intervention may cause a very large discrete change in the exchange rate. We analyse an example in which there is a target-zone policy in place but the actual width of the target zone is not known by participants in the foreign exchange market. In this case, intervention both affects fundamentals and conveys information about policy. The exchange rate jumps in response to intervention with the size of the jump related to the uncertainty about the true band width. Also in this model the relationship between the exchange rate and the fundamental depends upon both the history of the path of the exchange rate and whether or not intervention has occurred.
Abstract: In this paper, the small, but persistent interest rate differentials via-a-vis Germany which have existed in Austria, the Netherlands, and Belgium are analysed. These interest differentials may be thought of to consist of three parts: expected exchange rate movements within the band, expected changes of the central rates, and a risk premium. Following a similar test as proposed by Svensson, we examine the credibility of the exchange rate policy in these countries. According to this test, the Belgian exchange rate policy clearly lacks credibility for most of the period under consideration. There are, however, serious problems applying this test to Belgium due to the dual exchange rate system. For Austria and the Netherlands we calculate interest differentials which are adjusted for expected exchange rate movements within the band. It appears that the differences between the adjusted and the unadjusted interest differentials can be substantial. The Granger-causal relationship between fundamentals like the rate of inflation, the government budget deficit and the current account is also quite different for the adjusted and the unadjusted interest differential, where the fundamentals have the highest explanatory power for the latter measure.
Abstract: Using a panel data approach and three different credibility measures, we argue that unemployment, inflation, and budget deficits in participating countries have affected the credibility of the Exchange Rate Mechanism of the EMS. In contrast to most previous research, which focuses upon the credibility of exchange rate policies of individual member states, the analysis focuses upon the credibility of the system. The credibility indicators used are short- and long-term interest differentials vis-a-vis Germany and short-term interest differentials which have been adjusted for expected exchange rate movements within the band. Both long-term and error-correction models are estimated.
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Abstract: Nonparametric tolerance limits are employed to calculate soft margins such as advocated in Williamson's target zone proposal. In particular, the trade-off between softness and zone width is quantified. This may be helpful in choosing appropriate margins. Furthermore, it offers policymakers a framework for reference in the case of changing exchange rate policy. The empirical applications include an evaluation of the EMS zone width. We also show that the procedures for calculating the soft margins are robust against alternative data-generating mechanisms.
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Abstract: The desire to avoid speculative runs on currencies appears to be one of the main reasons leading policymakers to impose currency bands; but the standard analysis of target zones rules out any speculative inefficiencies by assumption. As an alternative, we first present simple models of excess volatility due to stop-loss trading; and then go on to consider what target zones might accomplish in this context. The principal result is that the speculation of informed traders shifts from being destabilising to stabilising, once the target zone assures them that stop-loss orders will not be triggered.
Abstract: This paper develops a simple model of exchange rate behaviour under target zone regime. It shows that the expectation that monetary policy will be adjusted to limit exchange rate variation affects exchange rate behaviour even when the exchange rate lies inside the zone and is thus not being defended actively. Somewhat surprisingly, the analysis of target zones turns out to have a strong formal similarity to problems in option pricing and investment under uncertainty.
Abstract: A collection of papers by Krugman on this topic.
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Abstract: A common rationale for membership in an exchange rate arrangement such as the EMS is that it may enhance the credibility of a central bank's commitment to stable monetary growth. In this paper, we consider this idea in the light of two other features of the EMS, namely the existence of exchange rate bands on the ongoing liberalisation of capital controls. We find that capital controls themselves affect credibility in a way that depends on the exchange rate bands. We also show that it is difficult to reconcile the non-zero width of the band with the credibility-based interpretation of the EMS.
Abstract: This paper explores the nature of the volatility transmission mechanism of three EMS (French franc, Dutch guilder and Belgian franc) and three non-EMS (Canadian dollar, US dollar and Japanese yen) exchange rates with respect to the German mark. The methodology used is the multivariate exponential GARCH model, which is capable of capturing asymmetries in the volatility transmission mechanism. The results pointed to significant volatility spillovers among markets for all rates except the yen, before Germany's unification. Evidence of asymmetry indicates that bad news in a particular market positively affects volatility in the next market more severely than good news does. Although absence of spillovers and asymmetry is revealed after unification for the EMS rates, the presence of asymmetry and persistence in volatility for the non-EMS rates is striking.
Abstract: This paper develops a model of central-bank intervention based upon a policy characteristic of foreign-exchange interventions by the United States, Germany, and Japan in the late 1980s and evaluates it empirically. Central bankers intervene with greater intensity as rates deviate from target levels, but they also try to stabilise rates around current levels. The model is estimated using exchange rates and data based upon observed central-bank interventions. Interestingly, the estimates of the model are consistent with the predictions of the theoretical model for both the Deutsche mark / dollar rate and, less strongly, for the yen / dollar rate. (originally NBER Working Paper No. 3398, July 1990)
Abstract: This paper develops a Bayesian approach to estimating exchange rate target zone models and rational expectations models in general. It also introduces a simultaneous-equation target zone model that incorporates stochastic realignment risk. Using FF/DM and IL/DM exchange rate data, we find that the signing of the 1987 Basle-Nyborg Agreement reduces both the magnitude and the likelihood of a central parity realignment, while the lagged exchange rate deviation from its central parity increases them. Furthermore, the interest rate policies and the monetary conditions of the participating countries signal a forthcoming realignment. In general, we are unable to improve upon a simple random walk model in out-of-sample exchange rate prediction by introducing target zone models. Full text available here.
Abstract: The Swedish exchange rate band is studied using daily data on exchange rates and interest rate differentials for the 1980s. Applying a number of different statistical and econometric techniques it is found that the first generation of target zone models cannot provide an adequate explanation of Swedish data. The main reasons are probably intramarginal interventions by the Swedish central bank and time varying devaluation expectations.
Abstract: The intervention policy of the Swedish central bank is studied using daily intervention data for the late 1908s. In contrast to the first generation of target zone models, the authors find that the interventions occur all over the exchange rate band and almost every day. Based on this evidence, they estimate an exchange rate target zone model with intramarginal interventions. The results go a long way towards explaining the well established hump-shaped exchange rate distribution and lack of non-linearities.
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Abstract: This text focuses on key issues like intervention in money and foreign exchange markets and credibility of EMS exchange rate bands. The book also re-opens the discussion on the "EMS discipline - credibility hypothesis" and the notion of "New EMS", testing both with an original methodology. The book is written with an empirical orientation.
Abstract: We employ two nonparametric nonlinear testing methodologies, namely a nonparametric nonlinear cointegration approach and a nonlinear Granger causality approach, to test for a nonlinear relationship between macroeconomic fundamentals and exchange rates for two country-pairs, namely the Netherlands - Germany and France - Germany. The results suggest that there is nonlinear cointegration among money, output and exchange rates for Netherlands - Germany, which can be interpreted as evidence of a long-run nonlinear relationship. For France - Germany, we fail to find evidence of nonlinear cointegration, but we find nonlinear Granger causality from French money to the French franc / Deutsche mark exchange rate. These findings may be interpreted as evidence of a dynamic nonlinear relationship and are consistent with the German dominance hypothesis. On the basis of estimated fractional ARIMA models, we rejected the hypothesis that these nonlinearities are due to bubbles.
Abstract: This paper presents evidence that two ERM exchange rates are Granger caused in a nonlinear fashion by relative money supply. This finding can be interpreted as evidence that the underlying relationship between money and exchange rates is nonlinear in a target zone arrangement, which is consistent with the target zone literature introduced by Krugman. Moreover, we find weak or no evidence that relative output nonlinearly Granger causes the exchange rate. Thus, relative money is more important than relative output in explaining the nonlinearity in the exchange rate - fundamentals relationship.
Abstract: This paper aims at investigating the behaviour of risk premia of currencies participating in the EMS against the dollar. For this purpose a multivariate GARCH in mean model is specified, allowing the risk premia of EMS currencies other than the Deutsche mark to be determined as a function of their conditional covariance with the Deutsche mark / dollar exchange rate. The risk premium of the latter is determined by its own conditional variance. The model is also able to capture the time varying character of the relationship between EMS currencies and the Deutsche mark. Furthermore, the model allows us to examine how changes in the conditional variances and covariances of future exchange rates affect the level of current exchange rates.
Abstract: This paper describes a procedure for estimating the market's perceived probability distribution of future exchange rates from the prices of risk reversals, strangles and other currency options, and uses the procedure to estimate the risk neutral ex ante probability of a realignment of the pound sterling. The procedure for estimating the realignment probabilities relies on the jump-diffusion model of exchange rate behaviour and the resulting option pricing formula. By fitting this model to market option price data, I retrieve the unobserved parameters of the jump-diffusion process. I then use these parameter estimates to estimate the ex ante probability distribution of exchange rates and thus the realignment probabilities.
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Abstract: Using Krugman's (1991) target zone model, we find an explicit, subgame-perfect solution for a central bank wishing to stabilise the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechanism (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion, and the welfare benefits are sufficient to sustain the system.
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Abstract: Exchange rate behaviour is analysed in the context of a stochastic rational expectations model in which there are random shocks to the price-setting mechanism and in which the authorities choose to impose either nominal or real exchange rate bands. The effects of rules for realignment of the band are also examined. Results are compared with those that emerge from a simple monetary model subject to velocity shocks.
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Abstract: This paper provides empirical support for the second generation of target zone models with stochastic devaluation risk. The author proposes a simple nonlinear framework with a time varying probability of exchange rate realignment. This model nests alternatives with no devaluation risk; with constant devaluation risk; and the random walk. He rejects these three in favour of a stochastic realignment model where devaluation risk varies with economic fundamentals. The model predicts 13 of 17 realignments for the Franc and Lira, including an out-of-sample episode in August 1993.
Abstract: Option prices seem to behave in ways inconsistent with the Black-Scholes model. Implied volatility varies with the strike price in a parabolic shape that is often called the volatility "smile." My objective in this paper is to identify implied probability distributions that might explain this anomaly. I develop a simulated method of moments estimation procedure. I parameterize the underlying exchange rate process as a mixture of log-normals, price the options using Monte Carlo methods, and compare these simulated price "moments" to the market data. This process switching model appears to be quite promising in explaining the volatility smile. Applying this to the ERM data, I find that the probability of a devaluation in the British Pound almost doubled before it withdrew from the ERM. This risk becomes statistically significant on September 15, 1992, only one day prior to the crisis though. The French Franc crisis of July - August 1993 appears to have been better anticipated. By July 20, 1993, the model predicts with 95% confidence that the Franc is going to be devalued.
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Abstract: We formulate a mathematical model for the optimal control of the exchange rate under uncertainty. The results are applied to the following situation: Suppose that a government has two means of influencing the foreign exchange rate of its own currency. We assume that the exchange rate is stochastic and that there are given costs involved in these two actions. It is also costly to have an exchange rate which deviates too much from a given central parity m. How does the government apply its two means of influence in order to keep the exchange rate as stable as possible with minimal expected costs? We formulate this problem mathematically as a combined stochastic control (1) and impulse control (2) problem, and we discuss the solution in a specific example.
Abstract: We formulate a mathematical model for the optimal control of the exchange rate under uncertainty. We give general sufficient conditions for its solution. Suppose that a government has two means of influencing the foreign exchange rate of its own currency. We assume that the exchange rate is stochastic and that there are given costs involved in these two actions. It is also costly to have an exchange rate which deviates too much from a given central parity. How does the government apply its two means of influence in order to keep the exchange rate as stable as possible with minimal expected costs? We formulate this problem mathematically as a combined stochastic control (1) and impulse control (2) problem, and we discuss the solution in a specific example.
Abstract: Using genetic programming, we find trading rules that generate significant excess returns for three of four EMS exchange rates over the out-of-sample period 1986 - 1996. Permitting the rules to use information about the interest rate differential proved to be important. The reduction in volatility resulting from the imposition of a narrower band may reduce trading rule profitability. Our results cannot be duplicated by commonly used moving average rules, filter rules or by two rules designed to exploit known features of target zone rates. There is no evidence that the excess returns are compensation for bearing systematic risk.
Abstract: This paper examines the relationship between the conditional volatility of target zone exchange rates and realignments of the system. To investigate this question, modified jump-diffusion Generalized Autoregressive Conditional Heteroskedasticity (GARCH) and absolute value GARCH models are fit to six exchange rates of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). Time-varying jump probability and absolute value GARCH models are effective in improving the fit of jump-diffusion models on target zone data. There is some evidence that conditional volatility is higher around the periods of realignments.
Abstract: In this paper we examine exchange risk premia employing a survey dataset of EMS exchange rates. We are able to test a risk premium model directly, i.e. without having to rely on the rational expectations assumption. Our results indicate that time-varying risk premia are present in almost all cases and that a GARCH-in-mean specification for the premium is often appropriate. Full text available here.
Abstract: In this paper, we study the statistical properties of EMS exchange rate returns. Our findings show that jumps, time-varying parameters and conditional leptokurtosis are pertinent features in the empirical distributions of EMS exchange rate returns. Allowance for fat tails, however, tends to reduce the measured frequency of jumps in the distributions to more realistic proportions. Most successful in capturing the relevant features of EMS exchange rate returns is a combined jump-GARCH model with conditionally t-distributed innovations.
Abstract: This paper presents results for devaluation expectations for the IR£ / Deutsche mark for the period of EMS membership. The methodology employed produces estimates of expected rates of devaluation by adjusting the interest rate differential by the expected rate of depreciation within the band. These estimates are then related to economic fundamentals. Expected rates of devaluation are found to be positively correlated with the IR£ / sterling exchange rate and marginally related to unemployment, the level of reserves and the balance of payments surplus.
Abstract: Once one recognises that governments borrow international reserves and exercise other policy options to defend fixed exchange rates during currency crises, the question arises: What factors determine a government's decision to abandon a currency peg or hang on? In a setting of purposeful action by the authorities, the possibility of self-fulfilling crises becomes important. Speculative anticipations depend on conjectured government responses, which depend, in turn, on how price changes, that are themselves fuelled by expectations, affect the government's economic and political positions. The circular dynamic implies a potential for crises that need not have occurred, but that do because market participants expect them to. In contrast to this picture, most previous literature on balance-of-payment crises ignores the response of government behaviour to markets. That literature, I argue, throws little light on events such as the ERM collapse of 1992-93. This paper then presents two different models in which crisis and realignment result from the interaction of rational private economic actors and a government that pursues well-defined policy goals. In both, arbitrary expectational shifts can turn a fairly credible exchange-rate peg into a fragile one.
Abstract: This paper studies policy rules with escape clauses, analysing as an example fixed exchange rate systems that allow member countries the freedom to realign in periods of stress. While well-designed, escape clause rules can raise society's welfare in principle, limited credibility makes it difficult to implement such rules in practise. An EMS type institution that imposes political costs on policymakers who realign may raise welfare, but can also produce equilibria far inferior to an irrevocably fixed exchange rate. Switches between multiple equilibria may have the character of sudden speculative attacks.
Abstract: This paper evaluates the role of macroeconomic fundamentals in generating episodes of speculative pressures on six currencies of the European Exchange Rate Mechanism (ERM). The observed regime changes are first estimated by a set of speculative pressure indicators; the contribution of economic fundamentals are then examined by using the implications of the basic speculative attack literature. In general, episodes of speculative pressures appear to be associated with a deterioration in economic fundamentals only for some of the sample currencies, confirming the view that consistent macro policies are necessary but not sufficient to ensure the maintenance of an exchange rate peg.