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The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk

  • Svensson, L.E.

The foreign exchange risk premium in an exchange rate target-zone regime with devaluation/realignment risks is derived. In contrast to previous literature, the exchange rate's heteroscedasticity within the band, as well as a separate devaluation/realignment risk, is taken into account. The risk premium is then the sum of two separate risk premia, arising from stochastic exchange rate movements within the band and from stochastic devaluations/realignments when the bank is shifted. Both real and nominal exchange rate premia are considered. The real and nominal risk premia from movements within the band are very small for narrow target zones and can therefore be disregarded. The real and nominal risk premia from devaluations/realignments are larger but still relatively small proportions of the expected rate of devaluation/realignment.

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Paper provided by Stockholm - International Economic Studies in its series Papers with number 475.

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Length: 25 pages
Date of creation: 1990
Date of revision:
Handle: RePEc:fth:stocin:475
Contact details of provider: Postal: UNIVERSITY OF STOCKHOLM, INSTITUTE FOR INTERNATIONAL ECONOMIC STUDIES, S- 106 91 STOCKHOLM SWEDEN.
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  1. Miller M. & Weller, P., 1990. "Exchange Rate Bands With Price Inertia," The Warwick Economics Research Paper Series (TWERPS) 337, University of Warwick, Department of Economics.
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  12. Frankel, Jeffrey A., 1988. "Recent Estimates of the Time-Variation in the Conditional Variance and in the Exchange Risk Premium," Department of Economics, Working Paper Series qt23c9q73d, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  13. Charles Engel, 1990. "On the foreign exchange risk premium in a general equilibrium model," Research Working Paper 90-06, Federal Reserve Bank of Kansas City.
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  23. Jeffrey A. Frankel., 1988. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," Economics Working Papers 8866, University of California at Berkeley.
  24. Penati, Alessandro & Pennacchi, George, 1989. "Optimal portfolio choice and the collapse of a fixed-exchange rate regime," Journal of International Economics, Elsevier, vol. 27(1-2), pages 1-24, August.
  25. Lars Hörngren & Anders Vredin, 1989. "Exchange risk premia in a currency basket system," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 125(2), pages 311-325, June.
  26. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
  27. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
  28. Francisco Delgado & Bernard Dumas, 1990. "Monetary Contracting Between Central Banks and the Design of SustainableExchange-Rate Zones," NBER Working Papers 3440, National Bureau of Economic Research, Inc.
  29. W. R. M. Perraudin, 1990. "Exchange Rate Bands with Point Process Fundamentals," IMF Working Papers 90/108, International Monetary Fund.
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