Target zones and exchange rates: An empirical investigation

This paper develops an empirical model of exchange rates in a target zone. The distribution of exchange rate changes is conditioned on a latent jump variable where the probability and size of a jump vary over time as a function of financial and macroeconomic variables. When there is no jump, the target zone is credible and exchange rate changes are constrained to remain within the target zone band. The paper revisits the empirical evidence from the European Monetary System regarding the conditional distribution of exchange rate changes, the credibility of the system, and the size of the foreign exchange risk premia. In contrast to some previous findings, we conclude that the French Franc/Deutschmark rate exhibits considerable nonlinearities, realignments are somewhat predictable, and the credibility of the system did not increase substantially after 1987. Moreover, our model implies that the foreign exchange risk premium becomes large during speculative crises. (C) 1998 Elsevier Science B.V.