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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
Contact details of provider: Web page: http://www.springerlink.com/link.asp?id=100323

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  1. Krugman, Paul & Miller, Marcus, 1993. "Why have a target zone?," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 38(1), pages 279-314, June.
  2. Svensson, L.E.O., 1990. "The Simplest Test of Target Zone Credibility," Papers 469, Stockholm - International Economic Studies.
  3. 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.
  4. Rose, Andrew K & Svensson, Lars E O, 1993. "European Exchange Rate Credibility Before the Fall," CEPR Discussion Papers 852, C.E.P.R. Discussion Papers.
  5. Wolff, Christian C P, 1987. " Forward Foreign Exchange Rates, Expected Spot Rates, and Premia: A Signal-Extraction Approach," Journal of Finance, American Finance Association, vol. 42(2), pages 395-406, June.
  6. Andrew K. Rose & Lars E.O. Svensson, 1991. "Expected and predicted realignments: the FF/DM exchange rate during the EMS," International Finance Discussion Papers 395, Board of Governors of the Federal Reserve System (U.S.).
  7. 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.
  8. Jeffrey Frankel & Steven Phillips, 1991. "The European Monetary System: Credible at Last?," NBER Working Papers 3819, National Bureau of Economic Research, Inc.
  9. Bertola, Giuseppe & Caballero, Ricardo, 1990. "Target Zones and Realignments," CEPR Discussion Papers 398, C.E.P.R. Discussion Papers.
  10. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  11. Bertola, Giuseppe & Svensson, Lars E O, 1991. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," CEPR Discussion Papers 513, C.E.P.R. Discussion Papers.
  12. Maurice Obstfeld, 1991. "Destabilizing Effects of Exchange-Rate Escape Clauses," NBER Working Papers 3603, National Bureau of Economic Research, Inc.
  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. 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.
  15. repec:cup:etheor:v:6:y:1990:i:1:p:17-43 is not listed on IDEAS
  16. 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.
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