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Target Zones and Interest Rate Variability

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  • Svensson, Lars E O

Abstract

The trade-off between interest rate variability and the width of an exchange rate target zone is examined, using the regulated Brownian motion model of target zones. It is shown that for narrow exchange rate bands, and for reasonable parameter values, the interest rate differential's asymptotic variability is increasing in the width of the exchange rate band; whereas for wide exchange rate bands it is slowly decreasing in this width. The interest rate differential's instantaneous variability is decreasing in the width of the exchange rate band. A narrow target zone differs from a completely fixed exchange rate regime in that the interest rate differential's instantaneous standard deviation is high and even increases when the zone narrows. The model is extended to include a realignment / devaluation risk, as well as an endogenous exchange rate risk premium. The risk premium is small for reasonable parameter values and does not matter much.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 372.

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Date of creation: Feb 1990
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Handle: RePEc:cpr:ceprdp:372

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Keywords: Interest Rate Variability; Regulated Brownian Motion; Risk Premia; Target Zones;

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References

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  1. Miller, M. & Weller, P., 1988. "Exchange Rate Bands And Realignments In A Stationary Stochastic Setting," The Warwick Economics Research Paper Series (TWERPS) 317, University of Warwick, Department of Economics.
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  3. Frankel, Jeffrey A., 1986. "The implications of mean-variance optimization for four questions in international macroeconomics," Journal of International Money and Finance, Elsevier, vol. 5(1, Supple), pages S53-S75, March.
  4. Kenneth A. Froot & Maurice Obstfeld, 1991. "Stochastic Process Switching: Some Simple Solutions," NBER Working Papers 2998, National Bureau of Economic Research, Inc.
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  16. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
  17. Frankel, Jeffrey A., 1988. "Recent Estimates of the Time-Variation in the Conditional Variance and in the Exchange Risk Premium," Department of Economics, Working Paper Series qt23c9q73d, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  18. Bernard Dumas, . "Pricing Physical Assets Internationally: A Non Linear Heteroskedastic Process for Equilibrium Real Exchange Rates," Rodney L. White Center for Financial Research Working Papers 25-89, Wharton School Rodney L. White Center for Financial Research.
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