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ERM bandwidths for EMU and after: evidence from foreign exchange options

  • JosÈ B. Campa
  • P.H. Kevin Chang
  • Robert L. Reider

Are the wide bands adopted in the summer of 1993 too large? The official answer is that wide bands offer a protection against speculative pressure, while exchange rates may be kept within narrower margins at the discretion of the authorities. Yet if exchange rate fixity and predictability are desirable, as implicitly assumed by the mere existence of the system, there must exist a trade-off between protection against speculative pressure and predictability. In that case, the bandwidth chosen should be as narrow as possible and yet unlikely to be challenged by the markets. This paper offers estimates of 'safe' bandwidths. For the long-term member currencies (French franc, peseta, Danish krone and escudo), the existing 15% bands are found to be unnecessarily wide: narrower 3.5% bands would capture at least 95% of expected exchange rate realizations over a three-month horizon. For the lira, Finnish markka and Swedish krone, wider bands of 5-6% would capture a similar amount of the exchange rate distribution. The pound's exchange rate expectations are the most dispersed, requiring 8.4% bands to capture 95% of exchange rate expectations. Copyright Centre for Economic Policy Research, Centre for Economic Studies, Maison des Sciences de l'Homme 1997.

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Article provided by CEPR & CES & MSH in its journal Economic Policy.

Volume (Year): 12 (1997)
Issue (Month): 24 (04)
Pages: 53-89

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Handle: RePEc:bla:ecpoli:v:12:y:1997:i:24:p:53-89
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