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
JEL(s): 431, 432
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.