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The Simplest Test of Target Zone Credibility

  • Svensson, L.E.O.

Under the assumption of no arbitrage, exchange rate target-zone credibility is tested by whether domestic interest rates fall within `rate-of-return bands' between the maximum and minimum home-currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest rate parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. Under the assumption that devaluations are a Poisson process, the expected exchange rate, the probability intensity and the expected size of a devaluation can be related. These tests are illustrated using data on the Swedish target zone between January 1987 and August 1990.

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Paper provided by Stockholm - International Economic Studies in its series Papers with number 469.

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Length: 17 pages
Date of creation: 1990
Date of revision:
Handle: RePEc:fth:stocin:469
Contact details of provider: Postal: UNIVERSITY OF STOCKHOLM, INSTITUTE FOR INTERNATIONAL ECONOMIC STUDIES, S- 106 91 STOCKHOLM SWEDEN.
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  1. Svensson, Lars E O, 1991. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," CEPR Discussion Papers 494, C.E.P.R. Discussion Papers.
  2. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  3. Svensson, Lars E O, 1991. "The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data," CEPR Discussion Papers 495, C.E.P.R. Discussion Papers.
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