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French-German Interest Rate Differentials and Time-Varying Realignment Risk

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  • Francesco Caramazza
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    Abstract

    This paper explores the determinants of expected rates of realignment of the French franc/Deutsche mark exchange rate during the period 1987-1991. It does so by first estimating expected parity changes and then relating these to economic variables that are believed to influence agents’ realignment expectations. Time-varying expected rates of realignment are estimated in two ways: one, by adjusting short-term euromarket interest rate differentials for the expected rate of change of the FF/DM exchange rate within the EMS fluctuation band and two, by the differential in the yield on long-term government bonds. The behavior of the exchange rate within the band is found to be consistent with mean reversion and the expected change is nontrivial. Thus, by filtering out the expected mean reversion within the band from short-term interest rate differentials more precise measures of expected changes in the central parity are obtained. Realignment expectations are found to be closely related to the evolution of fundamental economic variables and, for shorter horizons, the position of the franc in the fluctuation band.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 93/1.

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    Length: 28
    Date of creation: 01 Jan 1993
    Date of revision:
    Handle: RePEc:imf:imfwpa:93/1

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    Related research

    Keywords: Interest rate differential; Exchange rate realignments; European Monetary System; exchange rate; statistics; rate of change; foreign exchange; equation; exchange rates; financial statistics; foreign exchange reserves; equations; exchange rate band; standard errors; statistical significance; exchange reserves; exchange rate mechanism; exchange rate bands; forward exchange rate; standard error; dummy variable; forward exchange; statistic; exchange rate changes; exchange risk; probability; foreign exchange risk; spot exchange rate; constant term; cointegration; covariance; exchange rate uncertainty; estimation of equation; autocorrelation; estimation procedure; sampling; fluctuations in exchange rates; logarithms; explanatory power; hard currency; exchange rate policy; empirical method; exchange rate target; exchange rate expectations; fixed exchange rate; current exchange rate; exchange rate risks; exchange rate target zones; real exchange rate; random walk;

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    Cited by:
    1. repec:ebl:ecbull:v:5:y:2007:i:6:p:1-14 is not listed on IDEAS
    2. Brissimis, Sophocles N. & Sideris, Dimitris A. & Voumvaki, Fragiska K., 2005. "Testing long-run purchasing power parity under exchange rate targeting," Journal of International Money and Finance, Elsevier, vol. 24(6), pages 959-981, October.
    3. Jerome Henry & Jens Weidmann, 2005. "The French-German Interest Rate Differential Since German," International Finance 0503009, EconWPA.
    4. Pierre Siklos & Rod Tarajos, 1996. "Fundamentals and devaluation expectations in target zones: Some new evidence from the ERM," Open Economies Review, Springer, vol. 7(1), pages 35-59, January.
    5. Bordo, Michael D. & Macdonald, Ronald & Oliver, Michael J., 2009. "Sterling in crisis, 1964–1967," European Review of Economic History, Cambridge University Press, vol. 13(03), pages 437-459, December.
    6. Andrea Cipollini & Kostas Mouratidis & Nicola Spagnolo, 2008. "Evaluating currency crises: the case of the European monetary system," Empirical Economics, Springer, vol. 35(1), pages 11-27, August.
    7. Chen, Zhaohui & Giovannini, Alberto, 1997. "The determinants of realignment expectations under the EMS: Some empirical regularities," European Economic Review, Elsevier, vol. 41(9), pages 1687-1707, December.
    8. Peria, Maria Soledad Martinez, 1999. "A regime - switching approach to studying speculative attacks : focus on European Monetary System crises," Policy Research Working Paper Series 2132, The World Bank.
    9. Peter Tillmann, 2001. "The Regime-Dependent Determination of Credibility: A New Look at European Interest Rate Differentials," IWP Discussion Paper Series 02/2001, Institute for Economic Policy, Cologne, Germany.
    10. Olivier Jeanne, 1996. "Les modèles de crise de change : un essai de synthèse en relation avec la crise du franc de 1992-1993," Économie et Prévision, Programme National Persée, vol. 123(2), pages 147-162.
    11. Jeanne, Olivier, 1997. "Are currency crises self-fulfilling?: A test," Journal of International Economics, Elsevier, vol. 43(3-4), pages 263-286, November.
    12. Elias Belessakos & Michael Papaioannou, 1996. "Simple credibility tests of the ERM bands for the pound sterling and the Italian lira," Open Economies Review, Springer, vol. 7(3), pages 219-236, July.

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