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Quantitative modelling of the EUR/CHF exchange rate during the target zone regime of September 2011 to January 2015

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  • Lera, Sandro Claudio
  • Sornette, Didier

Abstract

Krugman (1991)'s target zone model for exchange rate dynamics has become the reference of a large part of this literature. Despite its simplicity and elegance, empirical evidence has been lacking, not least because it is difficult to capture the predicted non-linear relationship between the observable exchange rate and the non-observable fundamental value. This is why we propose a different approach. By inverting locally the relation between exchange rate and fundamental value, we derive analytical expressions for the conditional volatility and the probability density as a function of the exchange rate. This allows us to examine Krugman's prediction directly from historical data, and, furthermore, enables us to test the smooth pasting condition, which is intimately related to the no-arbitrage condition. Concretely, we study the performance of the euro/Swiss franc exchange rate in the extraordinary period from September 6, 2011 to January 15, 2015, when the Swiss National Bank enforced a minimum exchange rate of 1.20 Swiss francs per euro. We show that the data are well explained by the theory and conclude that Krugman's target zone model holds after all, but apparently only under extreme and sustained pressure that pushes continuously the exchange rate very close to the boundary of the target zone.

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  • Lera, Sandro Claudio & Sornette, Didier, 2016. "Quantitative modelling of the EUR/CHF exchange rate during the target zone regime of September 2011 to January 2015," Journal of International Money and Finance, Elsevier, vol. 63(C), pages 28-47.
  • Handle: RePEc:eee:jimfin:v:63:y:2016:i:c:p:28-47
    DOI: 10.1016/j.jimonfin.2016.01.002
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    Cited by:

    1. Buchholz, Manuel & von Schweinitz, Gregor & Tonzer, Lena, 2018. "Did the Swiss exchange rate shock shock the market?," IWH Discussion Papers 9/2018, Halle Institute for Economic Research (IWH).
    2. Cho-Hoi Hui & Chi-Fai Lo & Po-Hon Chau, 2017. "Can Exchange Rate Dynamics in Krugman¡¯s Target-zone Model be Directly Tested?Abstract: Despite Krugman's (1991) model being a benchmark for modelling target zones, empirical support has been sparse d," Working Papers 032017, Hong Kong Institute for Monetary Research.
    3. Daniel Broby & Raphael Faessler & Milenko Josavac & Christophe Dehut, 2016. "The Impact of the (2011) Devaluation of the Swiss Franc on Eurozone Equity Benchmark Diversification," International Journal of Economics and Financial Issues, Econjournals, vol. 6(3), pages 1270-1286.
    4. Yang, Yan-Hong & Shao, Ying-Hui & Shao, Hao-Lin & Stanley, H. Eugene, 2019. "Revisiting the weak-form efficiency of the EUR/CHF exchange rate market: Evidence from episodes of different Swiss franc regimes," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 523(C), pages 734-746.

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    More about this item

    Keywords

    Exchange rate dynamics; Target zone; Conditional volatility; Smooth pasting;
    All these keywords.

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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