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A Quasi-Bounded Target Zone Model - Theory and Application to Hong Kong Dollar

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Author Info

  • C. F. Lo

    (The Chinese University of Hong Kong and Hong Kong Institute for Monetary Research)

  • C. H. Hui

    (Hong Kong Monetary Authority and Hong Kong Institute for Monetary Research)

  • S. W. Chu

    (The Chinese University of Hong Kong)

  • T. Fong

    (Hong Kong Monetary Authority)

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    Abstract

    The exchange rate target zone literature has often suggested that mean reversion in an exchange rate within a zone can be taken as evidence that the system is credible. While the exchange rate system in Hong Kong is perceived as having a high degree of credibility, there is mixed empirical evidence to suggest that the HKD shows mean reversion. This paper proposes a quasi-bounded process for exchange rate dynamics within a target zone, consistent with a fully credible exchange rate band in which the exchange rate cannot breach the strong-side limit while the weak-side limit is only accessible under restricted conditions of the relationship between the parameters of the drift term and stochastic part of the process. Our empirical results suggest that this model can describe the dynamics of the Hong Kong dollar where the drifting force is an increasing function of foreign reserves.

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    Bibliographic Info

    Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 282012.

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    Length: 25 pages
    Date of creation: Nov 2012
    Date of revision:
    Handle: RePEc:hkm:wpaper:282012

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    Keywords: Stochastics Process; Target Zone; Bounded Process;

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    1. Andrew K. Rose & Lars E.O. Svensson, 1993. "European Exchange Rate Credibility Before the Fall," NBER Working Papers 4495, National Bureau of Economic Research, Inc.
    2. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
    3. Nieuwland, Frederick G M C & Verschoor, Willem F C & Wolff, Christian C P, 1994. "Stochastic trends and jumps in EMS exchange rates," Journal of International Money and Finance, Elsevier, vol. 13(6), pages 699-727, December.
    4. F. De Jong, 2001. "A Jump-diffusion Model for Exchange Rates in a Target Zone," Statistica Neerlandica, Netherlands Society for Statistics and Operations Research, vol. 55(3), pages 270-300.
    5. Myung Jig Kim & Charles R. Nelson & Richard Startz, 1988. "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," NBER Working Papers 2795, National Bureau of Economic Research, Inc.
    6. Angelos Kanas, 1998. "Testing for a unit root in ERM exchange rates in the presence of structural breaks: evidence from the bootstrap," Applied Economics Letters, Taylor & Francis Journals, vol. 5(7), pages 407-410.
    7. Ball, Clifford A. & Roma, Antonio, 1993. "A jump diffusion model for the European monetary system," Journal of International Money and Finance, Elsevier, vol. 12(5), pages 475-492, October.
    8. Ball, Clifford A. & Roma, Antonio, 1994. "Target zone modelling and estimation for European Monetary System exchange rates," Journal of Empirical Finance, Elsevier, vol. 1(3-4), pages 385-420, July.
    9. Anthony, Myrvin & MacDonald, Ronald, 1999. "The width of the band and exchange rate mean-reversion: some further ERM-based results," Journal of International Money and Finance, Elsevier, vol. 18(3), pages 411-428.
    10. Kristian Stegenborg Larsen & Michael Sørensen, 2007. "Diffusion Models For Exchange Rates In A Target Zone," Mathematical Finance, Wiley Blackwell, vol. 17(2), pages 285-306.
    11. Anthony, Myrvin & MacDonald, Ronald, 1998. "On the mean-reverting properties of target zone exchange rates: Some evidence from the ERM," European Economic Review, Elsevier, vol. 42(8), pages 1493-1523, September.
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