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A Drift of the "Drift Adjustment Method"

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  • Mundaca, Gabriela

    ()
    (Dept. of Economics, University of Oslo)

Abstract

This paper shows why regressing the realised rates of depreciation within the exchange rate band on a given information set and conditional on (ex-post) actual no-realignment (à la drift adjustment) still encounters a "Peso Problem". Such a procedure generally gives inconsistent estimates. The main reason is that the frequency of realignments in the data need no coincide with the frequency of the subjective (even small) probabilities that a realignment may take place. These probabilities cause jumps in the exchange rate even when it is conditional on actual no-realignment. When using an alternative approach that takes care of the peso problem and provides consistent estimates of the expected rate of realignment, we find that our estimates of the expected realignment (devaluation) rates are always greater than the ones obtained using the drift adjustment method.

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File URL: http://www.sv.uio.no/econ/english/research/unpublished-works/working-papers/pdf-files/2002/Memo-16-2002.pdf
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Bibliographic Info

Paper provided by Oslo University, Department of Economics in its series Memorandum with number 16/2002.

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Length: 35 pages
Date of creation: 17 Jun 2003
Date of revision:
Publication status: Published in Economica, 2004, pages 13-37.
Handle: RePEc:hhs:osloec:2002_016

Contact details of provider:
Postal: Department of Economics, University of Oslo, P.O Box 1095 Blindern, N-0317 Oslo, Norway
Phone: 22 85 51 27
Fax: 22 85 50 35
Email:
Web page: http://www.oekonomi.uio.no/indexe.html
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Related research

Keywords: Currency bands; realignments; drift adjustment method; regime switches;

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References

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  1. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
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  10. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
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  12. Bernard Dumas & L. Peter Jennergren & Bertil Naslund, 1993. "Realignment Risk and Currency Option Pricing in Target Zones," NBER Working Papers 4458, National Bureau of Economic Research, Inc.
  13. Svensson, Lars E O, 1991. "The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data," CEPR Discussion Papers 495, C.E.P.R. Discussion Papers.
  14. Bertola, Giuseppe & Svensson, Lars E O, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," Review of Economic Studies, Wiley Blackwell, vol. 60(3), pages 689-712, July.
  15. Kaminsky, Graciela, 1993. "Is There a Peso Problem? Evidence from the Dollar/Pound Exchange Rate, 1976-1987," American Economic Review, American Economic Association, vol. 83(3), pages 450-72, June.
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  18. Bertola, G. & Cabarello, R.J., 1990. "Target Zones And Realignments," Discussion Papers 1990_51, Columbia University, Department of Economics.
  19. Gabriela Mundaca, B., 2000. "The effect of interventions on realignment probabilities," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 10(3-4), pages 323-347, December.
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  22. Girardin, Eric & Marimoutou, Velayoudom, 1997. "Estimating the credibility of an exchange rate target zone," Journal of International Money and Finance, Elsevier, vol. 16(6), pages 931-944, December.
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  25. Chen, Zhaohui & Giovannini, Alberto, 1993. "The Determinants of Realignment Expectations Under the EMS - Some Empirical Regularities," CEPR Discussion Papers 790, C.E.P.R. Discussion Papers.
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