DP493 The Simplest Test of Target Zone Credibility
|Author(s):||Lars E.O. Svensson|
|Publication Date:||January 1991|
|Keyword(s):||Credibility, Devaluation Risk, Exchange Rates, Interest Rate Bands, Target Zones, Term Structure|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=493|
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.