1. Tsang, Shu-ki and Yue Ma (2001)

Currency substitution and speculative attacks on a currency board system

Abstract: A currency board arrangement (CBA) is supposed to be robust against attacks. Currency substitution complicates life, with controversial implications for floating versus fixed exchange rate regimes. After reporting evidence of currency substitution in Hong Kong, a monetary model incorporating currency substitution is used to estimate the shadow exchange rate and the probability of speculative attack on the Hong Kong dollar. A decomposition analysis of a Markov-switching model indicates that the no-attack regime was the most durable one. This implies that Hong Kong's quasi CBA was relatively robust against speculative attacks and currency substitution.

2. Rangvid, Jesper and Carsten Sorensen (2001)

Determinants of the implied shadow exchange rates from a target zone

Abstract: The paper provides a continuous time model of the dynamic behaviour of exchange rates and interest rates when exchange rates are managed within a target zone with the possibility of realignments. In the case of a realignment, the exchange rate jumps to a shadow exchange rate. The timing of realignments is modeled by a Cox process with an intensity that depends on the location of the exchange rate in the target zone band as well as the distance to the shadow exchange rate. We set up an approximate maximum likelihood estimation approach and provide parameter estimates for six ERM target zones. Moreover, in the empirical analysis we filter out the shadow exchange rates and investigate which fundamental macroeconomic factors are able to explain the short run and long run behaviour of the filtered shadow exchange rates. Working paper available here.

3. Serrat, Angel (2000)

Exchange rate dynamics in a multilateral target zone

Abstract: This paper presents a model of exchange rate behaviour in a multilateral target zone. The model produces new economic insights beyond the well-known bilateral model of Krugman (1991), which is obtained as a special case. The paper also introduces a new class of stochastic processes in economics, namely multidimensional reflected diffusion processes. Two main features characterise the economics of exchange rates in a multilateral target zone. (i) The restrictions on interventions imposed by cross-currency constraints: when one country changes its money supply, say because its exchange rate with a second country has hit its band, all exchange rates involving the currency of that particular country will be affected, regardless of their position within their respective bands. (ii) Cooperation in sharing the intervention burden: in general, the exchange rate between any two countries will depend on the fundamentals of third countries in a multilateral target zone. This is because if the monetary authorities intervene together, a shock in the fundamentals of any country will induce a revision of the expectation of future interventions of other countries. The model reverts the counterfactual predictions of the bilateral model that the exchange rate steady-state density should be U-shaped and that its volatility should be a decreasing function of the distance of the exchange rate to the limits of its band. Thus, accounting for the multilateral feature of real-world target zones allows us to reconcile target zone models with the most salient empirical features of exchange rate behaviour.

4. Anthony, M. and R. MacDonald (1999)

The width of the band and exchange rate mean-reversion: some further ERM-based results

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.

5. Dahlquist, Magnus and Stephen F. Gray (2000)

Regime-switching and interest rates in the European Monetary System

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.

6. Gray, H. P. and S. S. Rehman (editors) (1999)

The quest for exchange rate stability in the next millenium

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.

7. Esaka, Taro (2000)

The Louvre Accord and central bank intervention: Was there a target zone?

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.

8. Carrera, Jose M. (1999)

Speculative attacks to currency target zones: a market microstructure approach

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.

9. Forbes, Catherine S. and Paul Kofman (2000)

Bayesian target zones

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.

10. Coeure, Benoit and Jean Pisani-Ferry (1999)

The case against benign neglect of exchange rate stability

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.

11. Stockman, Alan (1999)

Choosing an exchange-rate system

Abstract: The focus of academic discussions of exchange rate policy has shifted in recent years. The new literature on exchange rate regime choice emphasizes considerations relating to the problems of credibility in exchange rate targeting and the connections between exchange rate regime choices and choices of monetary and fiscal policy. Arguments for exchange rate targeting are reviewed. Under most circumstances and for most countries, a system of freely floating exchange rates is likely to be a better choice than attempting to peg the exchange rate.

12. Woo, K.Y. (1999)

Cointegration analysis of the intensity of the ERM currencies under the European Monetary System

Abstract: This paper examines the (long-run) intra-zonal elasticities between the spot exchange rates of the Deutsche mark and other major ERM currencies (French franc, Belgian franc, Dutch guilder, Danish krone, Italian lira and British pound) under the EMS. The findings show that under the fixed-but-adjustable rate system, the hypothesis of no cointegration can be rejected for all chosen ERM currency pairs and unit restriction on zonal elasticities can be accepted for almost all cointegrated currency pairs. On the other hand, under the fixed-rate system, Danish krone, Italian lira and British pound fail the cointegration test and the zonal elasticities for all cointegrated currency pairs are rejected to be unity. The study signifies less intense linkages of the ERM currencies without parity realignments. Finally, the Deutsche mark took the role of error-correcting process for one cointegrated currency pair under the fixed-but-adjustable-rate system, and it performed the same role for two pairs under the fixed-rate system. Hence, Deutsche mark should not be assumed a priori statistically exogenous under the EMS.

13. Corrado, L. and S. Holly (2000)

A currency crisis model with a misaligned central parity: a stochastic analysis

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.

14. Torres, J. L. (2000)

An heterogeneous expectations target zone model

Abstract: This paper studies the credibility of a target zone considering the existence of heterogeneous expectations in the foreign exchange market. In general, we consider two types of agents: credible and non-credible agents (i.e. fundamentalists). One of the main results of the model is the possibility of collapse of a target zone as a function of expectations. This implies the existence of an endogenous realignment risk.

15. Ma, Yue and Angelos Kanas (2000)

Testing for a nonlinear relationship among fundamentals and exchange rates in the ERM

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.

16. Ma, Yue and Angelos Kanas (2000)

Testing for nonlinear Granger causality from fundamentals to exchange rates in the ERM

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.

17. Begg, D., F. Giavazzi, J. von Hagen and C. Wyplosz (1997)

EMU: Getting the endgame right. Monitoring European Integration No. 7

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.

18. Kempa, B. and M. Nelles (1999)

The theory of exchange rate target zones

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.

19. Fernandez-Rodriguez, F., S. Sosvilla-Rivero and J. Andrada-Felix (1999)

Exchange rate forecasts with simultaneous nearest neighbour methods: evidence from the EMS

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.

20. Kempa, B. and M. Nelles (1999)

Non-fundamental forex trading and excess volatility in credible target zones: theory and empirical evidence

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.

21. Kempa, B., Nelles, M. and C. Pierdzioch (1999)

The term structure of interest rates in a sticky price target zone model

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.

22. Neely, Christopher J. and Paul A. Weller (1999)

Technical trading rules in the EMS

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.

23. Pansard, Fabrice (1999)

Target zones and small realignments

Abstract: We study the behaviour of the exchange rate in a target zone in the case where a realignment may occur at the edges of the band. We show, in contrast to the previous result, that the stabilising property of the target zone may remain, even when the credibility is very low. Full text available here.

24. Holden, Steinar and Dag Kolsrud (1999)

Noisy signals in target zone regimes: theory and Monte Carlo experiments

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.

25. Pesaran, M. Hashem and F.J. Ruge-Murcia (1999)

Analysis of exchange rate target zones using a limited-dependent rational expectations model with jumps

Abstract: This paper examines exchange rate determination in a target zone regime when the bounds can be fixed for an extended period but are subject to occasional jumps. In this case, the behaviour of the endogenous variable is affected by the agents' expectations about both the occurence and the size of the jump. Empirical results using data for the French franc / Deutsche mark exchange rate provide support for the nonlinear model with time-varying realignment probability and indicate that the agents correctly anticipated most of the observed changes in the central parity.

26. Aschheim, J. and G. S. Tavlas (1998)

Two types of target zone proposals: McKinnon and Ohno versus Williamson

Abstract:

27. Campa, J. and P.H.K. Chang (1998)

ERM realignment risk and its economic determinants as reflected in cross-rate options

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.

28. Iannizzotto, Matteo and Mark Taylor (1999)

The target zone model, nonlinearity, and mean reversion: Is the honeymoon really over?

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.

29. Bodart, Vincent and Paul Reding (1999)

Exchange rate regime, volatility and international correlations on bond and stock markets

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.

30. Neely, Christopher J. (1999)

Target zones and conditional volatility: the role of realignments

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.

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