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Exchange rate expectations and risk premia in the European Monetary System: 1985–1991

  • Stefano Cavaglia
  • Kees Koedijk
  • Peter Vlaar

Using a new set of survey data on EMS exchange rates, we investigate exchange rate expectations and risk premia between December 1985 and August 1991 to assess credibility of the system. It appears that the EMS—with the exception of the Italian lira—had become credible since early 1990. Moreover, one of the core predictions of the target zone literature—the inverse correlation between the position of the spot rate in the fluctuation band with its expected change—is corroborated for several currencies in the period after April 1990. Although the system appeared to be more credible, the persistence of interest differentials suggested the existence of risk premia. For four out of six currencies we find a significant relationship between the risk premium and the inflation differential relative to Germany. Copyright Kluwer Academic Publishers 1994

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Article provided by Springer in its journal Open Economies Review.

Volume (Year): 5 (1994)
Issue (Month): 4 (October)
Pages: 347-360

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Handle: RePEc:kap:openec:v:5:y:1994:i:4:p:347-360
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  1. Krugman, Paul & Miller, Marcus, 1992. "Why Have a Target Zone?," CEPR Discussion Papers 718, C.E.P.R. Discussion Papers.
  2. Rose, Andrew K. & Svensson, Lars E. O., 1994. "European exchange rate credibility before the fall," European Economic Review, Elsevier, vol. 38(6), pages 1185-1216, June.
  3. Paul R. Krugman, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 669-682.
  4. Rose, Andrew K & Svensson, Lars E O, 1991. "Expected and Predicted Realignments: The FF/DM Exchange Rate During the EMS," CEPR Discussion Papers 552, C.E.P.R. Discussion Papers.
  5. Obstfeld, Maurice, 1991. "Destabilizing Effects of Exchange-Rate Escape Clauses," CEPR Discussion Papers 518, C.E.P.R. Discussion Papers.
  6. Svensson, L.E.O., 1990. "The Simplest Test of Target Zone Credibility," Papers 469, Stockholm - International Economic Studies.
  7. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
  8. Bertola, Giuseppe & Caballero, Ricardo J, 1992. "Target Zones and Realignments," American Economic Review, American Economic Association, vol. 82(3), pages 520-36, June.
  9. Frankel, Jeffrey & Phillips, Steven, 1992. "The European Monetary System: Credible at Last?," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 791-816, October.
  10. Robert J. Hodrick & Sanjay Srivastava, 1983. "An Investigation of Risk and Return in Forward Foreign Exchange," NBER Working Papers 1180, National Bureau of Economic Research, Inc.
  11. 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.
  12. Meese, Richard A & Rose, Andrew K, 1990. "Nonlinear, Nonparametric, Nonessential Exchange Rate Estimation," American Economic Review, American Economic Association, vol. 80(2), pages 192-96, May.
  13. Wooldridge, Jeffrey M., 1990. "A Unified Approach to Robust, Regression-Based Specification Tests," Econometric Theory, Cambridge University Press, vol. 6(01), pages 17-43, March.
  14. Wolff, Christian C, 1987. "Forward Foreign Exchange Rates, Expected Spot Rates, and Premia: A Signal-Extraction Approach," CEPR Discussion Papers 189, C.E.P.R. Discussion Papers.
  15. repec:cup:etheor:v:6:y:1990:i:1:p:17-43 is not listed on IDEAS
  16. Giuseppe Bertola & Lars E. O. Svensson, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," Review of Economic Studies, Oxford University Press, vol. 60(3), pages 689-712.
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