Abstract
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.
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