Exchange Rate Expectations, the Forward Exchange Rate Bias and Risk Premia in Target Zones

A method proposed by Bertola and Svensson (1993) is used to extract expected rates of depreciation within the target zone band for four Nordic currencies 1979-1989. These are then combined with time-series of expected rates of devaluation (defined as changes in central parities of the target zones) estimated by Edin and Vredin (1993). The result is time-series of the overall expected change in the exchange rate for the four currencies. Using these we can residually construct time-series of the foreign exchange risk premium and expectational errors. We find substantial and time-varying risk premia, why we question the widely used practice of assuming that UIP holds, e.g. when studying the credibility of target zone regimes. The estimated time-series of risk premia and expectational errors are used to attribute the forward exchange rate bias to expectational errors and/or risk premia, following a decomposition derived in Froot and Frankel (1989). We conclude that for the four Nordic countries studied in this paper - Denmark, Finland, Norway and Sweden - time-varying risk premia appear to be the dominant cause of deviations from UIP, while the role of expectational errors is less clear.