The recent theoretical literature on currency bands accounts for exchange rate behaviour within `target zones' by movements of their `fundamentals' and expectations of realignments. Under reasonable assumptions, if equilibrium exchange rates reflect these expectations, the yields of financial instruments denominated in different currencies should closely reflect their expected relative movement from the present until the instruments' maturities; but empirical research to date has provided limited support for the theoretical models' predictions.

In Discussion Paper No. 513, Research Fellows Giuseppe Bertola and Lars Svensson provide explicit solutions for the stochastic processes that the exchange rate and the expected rate of its depreciation follow over time, both of which they assume influence exchange rate and interest rate differentials. When the `devaluation risk' is high i.e. the public expects devaluation to be imminent or large the exchange rate weakens, which may trigger intervention in its defence even if the fundamentals have not changed.

Bertola and Svensson characterize the time-series behaviour of exchange rates and interest rate differentials under various realistic assumptions concerning the stochastic processes followed by the fundamentals and the devaluation risk. If the variability of the latter is relatively large, the relationship between exchange rates and interest rate differentials is very noisy. These results may explain a number of apparent inconsistencies in the available empirical literature on target zones. The authors also find that the yields of financial instruments of different maturities and currencies depend on the expected behaviour of devaluation risk over time. For a model with endogenous exchange rates and interest rate differentials jointly determined by (exogenous) fundamentals and devaluation risks, uncovered interest parity implies that short-term interest rate differentials on instantaneously-maturing bonds denominated in domestic and foreign currencies measure the exchange rate's expected rate of depreciation, from which in turn they can estimate the devaluation or realignment risk.

Bertola and Svensson conclude by noting from earlier work that the expected rate of depreciation over a finite time interval can be approximated by a linear function of the deviation from the central parity, so expected rates of devaluation may be computed from expected depreciation within the band and the corresponding interest rate differentials. These series may fruitfully be combined in future research with theoretical work on competitiveness, reserves, political credibility and other potential determinants of devaluations.

Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models
Giuseppe Bertola and Lars E O Svensson

Discussion Paper No. 513, February 1991 (IM)