Exchange Rate Management
Target zones

Any evaluation of governments' cooperation within the Exchange Rate Mechanism (ERM) of the EMS requires a measure of its credibility in convincing financial markets that there will be no future realignments of non-German member currencies against the Deutschmark. One common, `naïve' measure is the interest rate differential for a given maturity, but this is also affected by the possibility of exchange rate movements within the bilateral ERM bands. Since the expected capital gains and losses due to such movements can easily be of similar or indeed greater magnitude than the interest rate differentials commonly observed, this `raw' interest rate differential may be a very misleading indicator of realignment expectations. Obtaining more reliable measures of devaluation expectations by adjusting the differentials for possible rates of depreciation within the band requires only minimal assumptions, but the corresponding test of the band's credibility is in many cases inconclusive.
In Discussion Paper No. 580, Research Fellow Lars Svensson extends his previous work by instead estimating expected `within band' depreciations using standard econometric techniques and then subtracting these from the interest rate differentials. He applies this methodology to data on the seven original ERM member currencies for the period from March 1979 to May 1990. He finds that the `within band' movements were very regular and displayed strong reversion towards the central parity in contrast to those under a free float.
Svensson finds that for short maturities (one month) this adjustment to the interest rate differential substantially improves its performance as a measure of devaluation expectations, because exchange rates within the band display clear mean reversion and the expected rates of `within band' depreciation are sizeable. For sufficiently long maturities, however, expected rates of depreciation within the band are bounded by the width of the band and divided by the length of the maturity and therefore approximate to zero; in these cases the interest rate itself is an adequate measure.
Svensson illustrates this methodology by considering the exchange rate of the Danish krone against the Deutschmark during 1989. The interest rate differential was around 2.5% per annum for most of the year, and the expected rate of depreciation within the band was around 2.5%, yielding an expected rate of devaluation around 5%. This was approximately double the interest rate differential, which clearly indicates that the interest rate differential must be adjusted to obtain an accurate estimation of devaluation expectations.

Assessing Target Zone Credibility: Mean Reversion and Devaluation Expectations in the EMS
Lars E O Svensson

Discussion Paper No. 580, September 1991 (IM)