Abstract
This study provides an innovative empirical investigation of target zone models with stochastic realignment. The distinguishing point of this study, which has not been discussed in the previously, is that the probability of adjustments of central parity (i.e. realignment of target zone) can be appropriately described by Poisson distribution. Hence, we set the central parity process as the Poisson process. The present study applies a new regime switching econometric framework with time-varying realignment probability and time-varying volatility probability to evaluate the empirical fitness of the target zone theory with stochastic realignment. In practice, we estimate the regime-switching model by maximum likelihood estimation and investigate the t statistics of parameter estimates. Moreover, we also investigate the likelihood ratio test in order to get more statistical evidence. To compare with past studies, Engel and Hakkio (1996) and Bekaert and Gray (1998), the present study provides an innovative empirical evaluation of exchange rate target zone with stochastic realignment. The evidence of this study focuses on currencies in the North American Free Trade Agreement (NAFTA). We especially focus on the exchange rates of the Canadian dollar/U.S. dollar and the Mexican peso/ U.S. dollar. The empirical results indicate the Canadian dollar/U.S. dollar exchange rate exhibit significant exchange rate target zone phenomena with stochastic realignment. Relatively the Mexican peso/ U.S. dollar exchange rate does not exhibit such significant exchange rate target zone phenomena with stochastic realignment. We also find that exchange rate target zone with stochastic realignment can indeed stabilize the fluctuations of exchange rate.
Published Version
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