DP513 Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models

Author(s): Giuseppe Bertola, Lars E.O. Svensson
Publication Date: February 1991
Keyword(s): Devaluations, Exchange Rates, Interest Rate Differentials, Target Zones
JEL(s): 431, 432
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=513

In our model, an exchange rate fluctuates between given boundaries for random lengths of time and jumps discretely when devaluations occur. We provide explicit solutions for the stochastic processes followed by the exchange rate and by the expected rate of depreciation when the likelihood and the size of devaluations vary stochastically over time. The model produces realistic patterns of covariation between exchange rates and interest rate differentials, and provides interesting interpretations of available empirical evidence. We also specify a technique for inferrring the risk of devaluation from target-zone data.