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The Distribution of Exchange Rates in the EMS

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  • Charles Engel
  • Craig S. Hakkio

Abstract

Exchange rates of currencies in the Exchange Rate Mechanism of the EMS are characterized by long periods of stability interrupted by periods of extreme volatility. The periods of volatility appear at times of realignments of the central parities and at times when the exchange rate is within the ERM bands. We begin by considering a procedure for finding outliers based on measuring distance as a quadratic form. The evidence suggests that the exchange rates of the EMS can be described by a mixture of two distributions. We therefore model the exchange rate as switching between two distributions--one that holds in stable times and the other that holds in volatile times. In particular, we use Hamilton's Markov-switching model. In addition, we extend Hamilton's model by allowing the probability of switching from one state to another to depend on the position of the exchange rate within its EMS band. This model has the interesting implication that near the edge of the band, large movements--either realignments or large jumps to the center of the band--are more likely if the move to the edge of the band has been precipitous.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4834.

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Date of creation: Aug 1994
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Publication status: published as International Journal of Finance and Economics, Vol. 1, pp. 55-67. 1996.
Handle: RePEc:nbr:nberwo:4834

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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. Akgiray, Vedat & Booth, G Geoffrey, 1988. "Mixed Diffusion-Jump Process Modeling of Exchange Rate Movements," The Review of Economics and Statistics, MIT Press, vol. 70(4), pages 631-37, November.
  3. Tucker, Alan L & Pond, Lallon, 1988. "The Probability Distribution of Foreign Exchange Price Changes: Tests of Candidate Processes," The Review of Economics and Statistics, MIT Press, vol. 70(4), pages 638-47, November.
  4. Baillie, Richard T & Bollerslev, Tim, 2002. "The Message in Daily Exchange Rates: A Conditional-Variance Tale," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 60-68, January.
  5. 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.
  6. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, vol. 6(4), pages 119-144, Fall.
  7. Koedijk, C.G. & Schafgans, M.M.A. & Vries, C.G. de, 1990. "The tail index of exchange rate returns," Open Access publications from Tilburg University urn:nbn:nl:ui:12-3108722, Tilburg University.
  8. Koedijk, C.G. & Stork, P.A. & Vries, C.G. de, 1992. "Differences between foreign exchange rate regimes: The view from the tails," Open Access publications from Tilburg University urn:nbn:nl:ui:12-3108712, Tilburg University.
  9. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  10. Hamilton, James D. & Susmel, Raul, 1994. "Autoregressive conditional heteroskedasticity and changes in regime," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 307-333.
  11. Boothe, Paul & Glassman, Debra, 1987. "The statistical distribution of exchange rates: Empirical evidence and economic implications," Journal of International Economics, Elsevier, vol. 22(3-4), pages 297-319, May.
  12. Filardo, Andrew J, 1994. "Business-Cycle Phases and Their Transitional Dynamics," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 299-308, July.
  13. Park, Keehwan & Ahn, Chang Mo & Fujihara, Roger, 1993. "Optimal hedged portfolios: the case of jump-diffusion risks," Journal of International Money and Finance, Elsevier, vol. 12(5), pages 493-510, October.
  14. 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.
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