realignment risk and currency option pricing in target zones abstract this paper extends the krugman target zone model by including a realignment mechanism various properties of that realignment mechanism are discussed the movement of the exchange rate is governed both by a wiener process on fundamental and by a poisson jump process with endogenous realignment size the realignment mechanism is such that except in cases where a speculative attack occurs no jump in fundamental is needed to accompany the jump in the exchange rate a risk neutral valuation of currency options is constructed some properties of option values under realignment risk are illustrated by numerical results

nonlinear nonparametric nonessential exchange rate estimation a wide variety of empirical exchange rate mo dels have been estimated over the years but despite the considerable energies that have been devoted to this work the economics profession has remarkably little to show for itself there is little evidence that conclusively links the bilateral exchange rates of typical oecd countries to fundamental macroeconomic determinants of exchange rates such as money output relative prices or interest differentials coefficient estimates are notoriously unstable and frequently mis signed compared with theoretical predictions exchange rate equations do not fit particularly well and forecast no better than the simplest naive alternatives recently a new class of exchange rate models was introduced by paul krugman 1988 these models provide a potential reason for the poor performance of traditional exchange rate models because they are nonlinear if the exchange rate actually depends in a nonlinear way on exogenous macroeconomic fundamentals linear exchange rate models may work poorly even though the exchange rate is closely linked to fundamentals in this paper we provide a brief sketch of some of this work as well as some preliminary evidence on the actual performance of these nonlinear models in our empirical analysis we use a nonparametric estimator that can handle a wide variety of nonlinear phenomena we examine fixed exchange rate regimes where nonlinearities should be quite easy to detect however we do not find strong empirical support for the hypothesis that the incorporation of nonlinear effects significantly improves models of exchange rate determination in section i we briefly review the theoretical literature on nonlinear target zone exchange rate models linking this work to the tests for intrinsic bubbles we draw heavily on recent papers by kenneth froot and maurice obstfeld 1989a b our methodology and data are discussed in section ii section iii contains new empirical tests for nonlinearities in exchange rate models

why exchange rate bands monetary independence in spite of fixed exchange rates abstract the paper argues that the reason real world fixed exchange rate regimes usually have finite bands instead of completely fixed exchange rates between realignments is that exchange rate bands counter to the textbook result give central banks some monetary independence even with free international capital mobility the nature and amount of monetary independence is specified informally and in a formal model and quantified with swedish krona data altogether the amount of monetary independence appears sizable for instance an increase in the swedish krona band from zero to about 2 percent may reduce the krona interest rate s standard deviation by about a half

target zones and exchange rate dynamics this paper develops a simple model of exchange rate behavior under a target zone regime it shows that the expectation that monetary policy will be adjusted to limit exchange rate variation affects exchange rate behavior even when the exchange rate lies inside the zone and is thus not being defended actively somewhat surprisingly the analysis of target zones turns out to have a strong formal similarity to problems in option pricing and investment under uncertainty

on the mean reverting properties of target zone exchange rates a cautionary note abstract we estimate a franc mark target zone model and find a very limited honeymoon effect monte carlo experiments calibrated with the estimates caution against the use of standard linear tests for non mean reversion as indirect tests of the target zone model

banking with ethics strategic moves and structural changes of the banking industry in the aftermath of the subprime mortgage crisis this paper explores the behavior of the banking industry in the new business environment that arose after the subprime crisis the main hypothesis is that there are two major types of banking institutions conventional banks and ethical banks each has a distinct business model to test how they have reacted to the new environment factor analysis techniques have been used the main findings are twofold firstly the new financial context has indeed caused the behavior of mainstream banks to change within this group one can further distinguish between those that have tried to anticipate the changes by adopting a more responsible financial attitude and those that have merely modified their banking practice to comply with the new regulatory framework secondly there are the so called ethical banks interestingly their behavior has scarcely been altered by the new financial context the main conclusion is that the different response of both types of banks reflects the existence of a distinct business model

exchange rate bands with price inertia this problem by committing member states to taking suitable action to prevent cross parities from straying outside some given publicly announced range and williamson s proposal for target zones was explicitly aimed at preventing exchange rate misalignment among the principal industrial countries subsequently the louvre accord struck between members of the group of seven in i 987 involved unpublished commitments designed to constrain fluctuation between the u s dollar and the currencies of its major trading partners funabashi i988 given the obvious practical importance of understanding the implications of such policy commitments for the economy in general and the exchange rate in particular it is perhaps not surprising that the seminal work by krugman i 988 i989 on exchange rate determination within a band has aroused considerable interest under the assumption that the velocity of money follows a brownian motion process he obtains an explicit solution for the exchange rate as a function of the fundamental which shows that the presence of a commitment to intervene so as to defend the band exerts a stabilising influence on the exchange rate even before any such intervention takes place in their contribution to this emerging literature froot and obstfeld i989 note that krugman s minimalist stochastic specification can be derived from a monetary model of exchange rates where prices are perfectly flexible and full employment prevails where international interest differentials match expected exchange rate changes and the exchange rate preserves purchasing power parity cf mussa 1976 and they show that the behaviour of the rate inside a currency band can be obtained using results on regulated brownian motion processes cf harrison i985 using the same framework and techniques flood and garber i989 indicate how the rate will respond to noninfinitesimal intervention and svensson i 989 examines the effect of bandwidth on the stochastic behaviour of interest rates klein i989 considers the effects of uncertainty about the width of the band

expected and predicted realignments the ff dm exchange rate during the ems an empirical model of time varying realignment risk in an exchange rate target zone is developed expected rates of devaluation are estimated as the difference between interest rate differentials and estimated expected rates of depreciation within the exchange rate band using french franc deutsche mark data during the european monetary system the behavior of estimated expected rates of depreciation accord well with the theoretical model of bertola svensson 1990 we are also able to predict actial realignments with some success

an interpretation of recent research on exchange rate target zones how do exchange rate bands work compared to completely fixed rates between realignments or more precisely what are the dynamics of exchange rates interest rates and central bank interventions within exchange rate bands does the difference between bands and completely fixed exchange rates matter and if so which of the two arrangements is best or more precisely what are the tradeoffs that determine the optimal bandwidth this article will present an interpretation of some selected recent theoretical and empirical research on exchange rate target zones with emphasis on main ideas and results and without technical detail

the linkage between speculative attack and target zone models of exchange rates in this paper we generalize the target zone exchange rate as model formalized by krugman 1988b to include finite sized interventions in defense of the zone the main contributions of these pages consist of linking the recent developments in the theory of target zones to the mirror image theory of speculative attacks on asset price fixing regimes and in using aspects of that linkage to give an intuitive interpretation to the smooth pasting condition usually invoked as a terminal condition this abstract was borrowed from another version of this item

anomalies foreign exchange most all behavior can be explained by assuming that agents have stable well defined preferences and make rational choices consistent with those preferences in markets that eventually clear an empirical result qualifies as an anomaly if it is difficult to rationalize or if implausible assumptions are necessary to explain it within the paradigm this column will present a series of such anomalies readers are invited to suggest topics for future columns by sending a note with some reference to or better yet copies of the relevant research comments on anomalies printed here are also welcome the address

playing with the band dynamic effects of target zones in an open economy this paper applies techniques of regulated brownian motion to a model of a small open economy to investigate how bands on fundamental driving variables affect the realization of the nominal exchange rate the real exchange rate prices and output the author shows that these bands mitigate the relationship between exogenous fundamentals and endogenous variables through their effects on expectations he also considers the effects of changing the width of the band and finds greater stabilization of endogenous variables with more narrow bands on exogenous fundamentals copyright 1990 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association

target zones and realignments recent contributions emphasize that the presence of exchange rate target zones has important effects on the within band behavior of exchange rates when agents are forward looking the authors find that the implications of available models are inconsistent with european exchange rate data and they suggest that the frequent realignments occurring in the period they consider may be responsible for this they construct a model in which the likelihood of a realignment in the near future increases as the exchange rate approaches the limits of its fluctuation band and show that its implications are broadly consistent with the evidence copyright 1992 by american economic association

monetary contracting between central banks and the design of sustainable exchange rate zones abstract an exchange rate system is a contract which commits central banks to intervene in the foreign exchange market the design features of the system include the rules of intervention the limits placed on exchange rates and the crisis scenario describing possible transitions to new regimes this paper considers the various trade offs one faces in designing an exchange rate system one of these pertains to the amount of reserves which the central banks must have on hand in order to forestall a speculative attack and make the system sustainable the amount of reserves needed depends crucially on the assumed crisis scenario

stochastic devaluation risk and the empirical fit of target zone models in the model of this paper an exchange rate fluctuates between given boundaries for random lengths of time and jumps discretely when devaluation 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 how to infer devaluation risk from target zone data

exchange rates under ems target zones an econometric investigation this study tests krugman s model on exchange rate target zones using four old ems exchange rates those of the currencies of belgium france italy and the netherlands against the deutsche mark vast theoretical literature is available but there are very few empirical studies testing the main results of krugman s model namely the honeymoon effect smooth pasting and the overall s curved relationship between fundamental and exchange rate the present study supports the honeymoon effect but does not find any evidence in support of smooth pasting or of an s curved relationship between the exchange rate and fundamentals for the belgian franc french franc and italian lira against the deutsche mark the dutch guilder very closely follows movements in the german mark throughout the period 1981 90 end of month exchange rates and euro currency interest rates data are used

implied exchange rate distributions evidence from otc option markets abstract this paper uses a rich new dataset of option prices on the dollar mark dollar yen and key ems cross rates to extract the entire risk neutral probability density function pdf over horizons of 1 and 3 months we compare three alternative smoothing methods cubic splines an implied binomial tree trimmed and untrimmed and a mixture of lognormals for transforming option data into the pdf despite their methodological differences the three approaches lead to a similar pdf clearly distinct from the lognormal benchmark and typically characterized by skewness and leptokurtosis we then document a striking positive correlation between skewness in these pdfs and the spot rate the stronger a currency the more expectations are skewed towards a further appreciation of that currency we interpret this finding as a rejection that innovations in these exchange rates are independent of the level or characteristic of a credible target zone explicit or implicit instead this positive correlation is consistent with target zones with endogenous realignment risk we discuss two interpretations of our results on skewness when a currency is stronger the actual probability of further large appreciation is higher or because of risk such states are valued more highly

exchange rate management and macroeconomic policy a national perspective this paper reviews the literature on alternative exchange rate arrangements for a small economy it discusses exchange rate management for short run stabilization purposes and the choice of exchange rate regimes to foster policy discipline recent research has emphasized that the appropriate degree of exchange rate flexibility depends on the nature of disturbances exchange rate movements provide information about shocks and can serve as a basis for intervention rules empirically operational guidelines have not yet been provided floating rates are said to be desirable because they allow policy makers greater autonomy recent research has questioned the implicit assumption that autonomy is always useful rules that prevent discretionary policy may be preferable what role if any the exchange rate should play in such rules has not yet been resolved

the case for roughly stabilizing the real value of the dollar the title of my paper implies the following five claims 1 it is possible for macroeconomic policy to influence exchange rates in a substantive way 2 it is desirable that macroeconomic policy target the exchange rate 3 it is nevertheless desirable to leave substantial latitude for exchange rates to fluctuate around their target levels 4 the target should be a real rather than nominal exchange rate 5 the real value of the dollar was broadly appropriate when this paper was written december 1988 the paper is devoted to explaining the basis for these five propositions

viewpoint empirical evidence and tax policy design lessons from the mirrlees review this paper examines the role of evidence in drawing up the recommendations for tax reform in the mirrlees review the arguments are organised loosely under five related headings i key margins of adjustment ii measurement of effective tax rates iii the importance of information and complexity iv evidence on the size of responses v implications from theory for tax design although the mirrlees review focuses on all aspects of tax reform the focus is this paper is on the taxation of earnings with some examples drawn from the taxation of consumption and savings ce memoire examine le role des resultats dans la confection des recommandations pour la reforme fiscale dans l enquete mirrlees les arguments sont regroupes sous cinq rubriques i les importantes marges d ajustement ii la mesure des taux d imposition effective iii l importance de l information et de la complexite iv constat sur la taille des reponses et v les implications pour la theorie du design des politiques d imposition meme si l enquete mirrlees a examine tous les aspects de la reforme fiscale ce texte met l accent sur l impot sur les remunerations avec quelques exemples portant sur l impot sur la consommation et l epargne

the foreign exchange risk premium in a target zone with devaluation risk abstract the foreign exchange risk premium in an exchange rate target zone is derived when the exchange rate is heteroskedastic within the band and there is a separate devaluation risk the risk premium is then the sum of two separate risk premia arising from uncertainty about exchange rate movements within the band and from uncertainty about devaluations both real and nominal risk premia are considered real and nominal risk premia from movements within the band are very small real and nominal risk premia from devaluations are larger but still relatively small proportions of the interest rate differential