Exchange Rate Target Zone Research Articles

Can one hear the shape of a target zone?

We develop an exchange rate target zone model with finite exit time and non-Gaussian tails. We show how the tails are a consequence of time-varying investor risk aversion, which generates mean-preserving spreads in the fundamental distribution. We solve explicitly for stationary and non-stationary exchange rate paths, and show how both depend continuously on the distance to the exit time and the target zone bands. This enables us to show how central bank intervention is endogenous to both the distance of the fundamental to the band and the underlying risk. We discuss how the feasibility of the target zone is shaped by the set horizon and the degree of underlying risk, and we determine a minimum time at which the required parity can be reached. We prove that increases in risk beyond a certain threshold can yield endogenous regime shifts where the “honeymoon effects” vanish and the target zone cannot be feasibly maintained. None of these results can be obtained by means of the standard Gaussian or affine models. Numerical simulations allow us to recover all the exchange rate densities established in the target zone literature. The generality of our framework has important policy implications for modern target zone arrangements.

MONETARY CHALLENGES OF EMERGING EUROPEAN ECONOMIES TOWARDS THE EURO ZONE

The paper aims to highlight the main difficulties on the monetary path towards the euro zone experienced by Emerging Europe. Emerging European Economies (EEEs), EU members, adopted either double shift or smooth transition monetary approach towards the euro zone. Double shift assumes changes from floating exchange rate regimes (ERRs) to the ERM II target zone and, finally, monetary union as a rigid ERR. The smooth transition is practiced by economies with mainly rigid ERRs before the ERM II entrance and, at the end, again rigid ERR of a monetary union. Despite chosen monetary path towards the euro zone, crucial difficulties or aggravating factors could be identified in the form of real exchange rate appreciation due to productivity growth or capital inflows. A reconciliation of inflation and exchange rate target zone is extremely complex, at the same time striving not to jeopardize the real convergence. What is stressed here is the vicious cycle between real and nominal convergence as the reason why the ERM II target should be regarded as a “waiting room“ not as a “training room“ in the pre-EMU phase.

Exchange rate policy and external vulnerabilities in Sub-Saharan Africa: nominal, real or mixed targeting?

ABSTRACT This paper discusses the theoretical choice of exchange rate regimes in Sub-Saharan African countries that are facing external vulnerabilities. To reduce instability, policymakers choose among promoting external competitiveness using a real anchor, lowering the burden of foreign debt using a nominal anchor or using a policy mix of both anchors. We observe that these countries tend to adopt mixed anchor policies. We solve a state space model to explain the determinants of and the strategy behind this policy. We find that the mixed targeting policy is a two-step strategy: First, monetary authorities choose the degree of nominal exchange rate flexibility according to the velocity of money, trade openness, foreign debt, degree of exchange rate pass-through and exchange rate target zone. Second, authorities seek to stabilize the real exchange rate depending on the degree of competition in the domestic goods market and the degree of foreign exchange intervention. We conclude with regime-switching estimations to provide empirical evidence of how these economic fundamentals influence exchange rate policy in Sub-Saharan Africa.

Unique Fundamental Dynamics of Target-zone Exchange Rates

We have provided a rigorous derivation of the asymmetric mean-reverting fundamental dynamics proposed by Lo and coworkers (2015) for target-zone exchange rates, and have shown that the proposed fundamental dynamics is the unique choice and described by the Rayleigh process. By analogy, such a fundamental can be treated as a one-dimensional overdamped Brownian particle moving in a logarithmic-harmonic potential well. In addition, we have demonstrated that the predicted exchange rate distributions can take several different shapes, which may correspond to possible realignments and widely different (marginal and intra-marginal) intervention policies. The shapes of these distributions represent the predicted distributions discussed in previous theoretical models which only generate one or two shapes. Moreover, we have succeeded in performing explicit calibration of the proposed fundamental dynamics, thus confirming the validity of our model. Unlike the Krugman model, our model is capable of explaining the empirical observations that the exchange rate dynamics is sticky near the edges of the band, and that both positive and negative interest rate differentials can appear in the entire target zone.

Currency Target Zones as Mirrored Options

This article presents a new way of modeling the dynamics of an exchange rate target zone. In the presence of a single upper (lower) target boundary, the exchange rate is precisely represented as the sum of a free float and a short (long) position in a call (put) option with strike price at the boundary. To model a target zone (with two boundaries), a natural approach consists of describing the exchange rate dynamics as the combination of the two, namely the sum of free float together with a long position in a put written on the lower boundary and a short position in a call option written on the upper boundary, respectively. The authors show that this first order approximation leads to significant mispricing (as much as 20%) and must be iterated, leading to an infinite sequence of compounded “mirrored” option prices. They analyze basic properties of such mirrored nested options analytically, describe how to calculate them numerically, and show why it is crucial to take into account higher order corrections in realistic target zones. They argue that this analogy to option prices allows for conceptually simple generalizations that describe different target zone arrangements. They then apply their methodology to the estimation of the fundamental value of the Hong Kong dollar that is hidden by the target zone pegged to the US dollar. They also estimate the implied maturity and explain how this parameter serves as direct proxy for target zone credibility.

Informal one‐sided target zone model and the Swiss franc

AbstractThis paper develops a new theoretical model with an asymmetric informal one‐sided exchange rate target zone, with an application to the Swiss franc following the removal of the minimum exchange rate of CHF 1.20 per euro in January 2015. We extend and generalize a standard target zone model by introducing perceived uncertainty about the lower edge of the band. We find that informal soft edge target zone bands lead to weaker honeymoon effects, wider target zone ranges, and higher exchange rate volatility than formal target zone bands. These results suggest that it would be beneficial for exchange rate policy intentions to be stated clearly in order to anchor exchange rate expectations and reduce exchange rate volatility. We also study how exchange rate dynamics can be characterized in models in which financial markets are aware of occasional changes in the policy regime. We show that expected changes in the central bank's exchange rate policy may lead to exchange rate oscillations, providing an additional source of exchange rate volatility, and to capture this it is important to take into account the possibility of regime changes in exchange rate policy.

INTEREST RATE TARGETS AND SPECULATIVE ATTACKS ON PUBLIC DEBT

The application of exchange rate target zones modeling to interest rates allows interpreting the puzzles that emerged with the public debt euro area crisis, namely the nonlinear behavior of the interest rates and the fact that some stand-alone countries, not belonging to the euro area, have not been subject to speculative attacks in spite of equally large public debt-to-gross domestic product (GDP) ratios. As a matter of fact, this model shows that in the case of a noncredible upper threshold for the interest rate (that may be due to both the lack of room for increasing further the required government primary surplus and/or the absence of a monetary authority acting as a lender of last resort), the resulting public debt unsustainability determines an interest rate nonlinearity and makes the crisis possible for public debt levels that would be stable in the presence of a credible interest rate target.

A MODEL OF INFLATION TRANSMISSION IN AN EXCHANGE RATE TARGET ZONE

I incorporate an exchange rate target zone with intramarginal interventions in a small open economy model. Using the method of undetermined coefficients, I solve for the price level and the nominal exchange rate to determine how price shocks from the large economy affect the small open economy. The results show that the behaviour of inflation transmission within the band differs from the behavior of inflation transmission at the edge of the band of the target zone. Foreign shocks can affect local prices in both cases but the central bank can respond through market interventions within the band while it cannot do so at the edge. Near the edge of the band, a central bank has to intervene to stop the exchange rate from breaching the band. My model predicts that if the interventions are robust, then the exchange rate is mean reverting and an exchange rate target zone can insulate an economy from foreign price shocks. Based on the model, central bank interventions contribute to long-run price stability in a target zone regime. Finally, I empirically test the model using unit root and cointegration tests, and present some policy implications.

Currency Target Zones as Mirrored Options

A new way of modeling the dynamics of an exchange rate target zone is presented. In the presence of a single upper (resp. lower) target boundary, the exchange rate is precisely represented as the sum of a free float and a short (resp. long) position in a call (resp. put) option with strike price at the boundary. To model a target zone (with two boundaries), a natural approach consists in describing the exchange rate dynamics as the combination of the two, namely the sum of free float together with a long position in a put written on the lower boundary and a short position in a call option written on the upper boundary, respectively. We show that this first order approximation leads to significant mispricing (as much as 20%) and must be iterated, leading to an infinite sequence of compounded 'mirrored' option prices. We analyze basic properties of such mirrored nested options analytically, describe how to calculate them numerically, and show why it is crucial to take into account higher order corrections in realistic target zones. We argue that this analogy to option prices allows for conceptually simple generalizations that describe different target zone arrangements. We apply our methodology to the estimation of the fundamental value of the Hong Kong dollar that is hidden by the target zone peg to the US dollar. We also estimate the implied maturity and explain how this parameter serves as direct proxy for target zone credibility.

The Costs of Implementing a Unilateral One-Sided Exchange Rate Target Zone

Abstract In the aftermath of the recent financial crisis, the central banks of small open economies such as the Swiss National Bank (SNB) implemented a unilateral one-sided exchange rate target zone vis-à-vis the euro currency to counteract deflationary pressures. Recently, the SNB abandoned its minimum exchange rate regime, arguing that after having analyzed the costs and benefits of this non-standard exchange rate policy measure, it was no longer sustainable. This paper proposes a model that allows central banks and policymakers to estimate ex-ante the costs of implementing and maintaining a unilateral one-sided target zone (in terms of the expected size of foreign-exchange interventions) and to monitor these costs during the period in which it is enforced. The model also offers central banks a tool to identify the right timing for the discontinuation of a minimum exchange rate regime. An empirical application to the Swiss case shows the ex-ante estimated size of these costs and reveals that these costs might have been substantial without the abandonment of the minimum exchange rate regime, which accords with the official statements of the SNB.

Exchange Rate Policies and Monetary Union E ffectiveness in the East Africa Community

This paper assesses the effectiveness of East Africa Monetary Union under alternative exchange rate policies. We model four types of exchange rate policies in a two-open economy Dynamic Stochastic General Equilibrium model with financial micro-foundations. Findings reveal that floating exchange rate policy is preeminent for East Africa monetary union effectiveness. Partner states case study demonstrates that, first, wealth effect expansionary features are not driven under pegged exchange rate policy. Second, monetary policy transmission mechanism is ambiguous under target zone exchange rate policy. Third, Fisher effect dampening impact arises under managed floating exchange rate policy and lasts over time.

An Empirical Investigation of the Monetary Model Economic Fundamentals

This paper presents an empirical investigation of an important series called “economic fundamentals” derived from the flexible price monetary model of exchange rate determination. The model predicts that the nominal exchange rate is determined by the “economic fundamentals”, referred here as the series ft. As a result, the characteristics of the “economic fundamentals” process may influence the properties of the nominal exchange rate process. We will just use the term “fundamentals”. Nevertheless, many exchange rate models found in the literature assume an ad-hoc process for ft ignoring the fact that the specification of this process can be formally derived within the framework of the monetary model. Using data for several countries on GDP and money supplies, we construct the series ft according to the monetary model specification, and we examine some important characteristics of its empirical distribution such as skewness, kurtosis, stationarity, ARCH and GARCH properties. We observe that the series is not exactly normally distributed, as commonly assumed in many target zone models. This investigation essentially helps with modeling exchange rate and more importantly in the analysis of exchange rate target zones modeling by identifying potential restrictions that need to be taken into consideration when choosing a process for the modeling of the “economic fundamentals”.

A Target Zone Model Where the Fundamentals Follow a Geometric Brownian Motion

In this paper, we propose a model of exchange rate target zone based on a specification of the economic fundamentals known as a Geometric Brownian Motion. The rationale behind this specification is that the fundamentals series is not necessarily normally distributed as commonly assumed, as indicated by its excess kurtosis and ARCH properties. Therefore, assuming a normal specification can be problematic. The main difficulty is that with such a specification finding a closed form solution for the model becomes somehow more involved. We present some results in which the exchange rate formula is explicitly derived. Then we look at several types of central bank interventions in the foreign exchange market such as Krugman’s marginal interventions, central bank interventions a la Caballero and central bank interventions a la Flood-Garber. In addition, we present some empirical investigations where it is found that, for the most part, these exchange rate models do not fit the data well and a case where the model performs satisfactorily. We believe that the sources of the problem may reside in the complexity of estimating the models efficiently given that the theoretical approach is quite sound.

The Costs of Implementing a Unilateral One-Sided Exchange Rate Target Zone

In the aftermath of the recent financial crisis, the central banks of small open economies such as the Swiss National Bank (SNB) implemented a unilateral one-sided exchange rate target zone vis-a-vis the euro currency to counteract deflationary pressures. Recently, the SNB abandoned its minimum exchange rate regime, arguing that after having analyzed the costs and benefits of this non-standard exchange rate policy measure, it was no longer sustainable. This paper proposes a model that allows central banks and policymakers to estimate ex-ante the costs of implementing and maintaining a unilateral one-sided target zone (in terms of the expected size of foreign-exchange interventions) and to monitor These costs during the period in which it is enforced. The model also offers central banks a tool to identify the right timing for the discontinuation of a minimum exchange rate regime. An empirical application to the Swiss case shows the ex-ante estimated size of these costs and reveals that these costs might have been substantial without the abandonment of the minimum exchange rate regime, which accords with the official statements of the SNB.

On the sustainability of exchange rate target zones with central parity realignments

Abstract I show that parity realignments alone do not suffice to ensure the long-run sustainability of an exchange rate target zone with imperfect credibility due to the gambler’s ruin problem . However, low credibility and frequent realignments can destabilize the exchange rate.

On the Sustainability of Exchange Rate Target Zones with Central Parity Realignments

I show that parity realignments alone do not suffice to ensure the long-run sustainability of an exchange rate target zone with imperfect credibility due to the gambler's ruin problem. However, low credibility and frequent realignments can destabilize the exchange rate.

Properties of the Cox–Ingersoll–Ross Interest Rate Processes with Two-sided Reflections

In recent years, reflected diffusion processes have played an important role in mathematical finance because of the existence of the constraint policies to special economic regime, such as a storage system, the exchange rate target-zone dynamics, barrier options, and so on. We are to propose a class of Cox–Ingersoll–Ross interest rate processes which has double sided reflected barriers so that the central bank can constrain the interest rate to fluctuate within a pre-specified zone. In this paper, we are mainly interested in the stationary distribution and first hitting times about the reflected Cox–Ingersoll–Ross interest rate processes. Therefore, we will supply an explicit expression of the stationary distribution and some related analytic formulas of first passage times.

On the Sustainability of Exchange Rate Target Zones with Central Parity Realignments

On the Sustainability of Exchange Rate Target Zones with Central Parity Realignments

On the Sustainability of Exchange Rate Target Zones with Central Parity Realignments

On the Sustainability of Exchange Rate Target Zones with Central Parity Realignments

Probability Analysis of Exchange Rate Target Zones

The objective of this paper is to show quantitative results for the exchange rate target zones in a small open economy. We develop a stochastic model for exchange rates under the equilibrium in goods and money markets based on a variation of Dornbusch (1976)'s model, incorporating several kinds of macroeconomic shocks and a noneconomic factor ignored by literature. Using the theory of stochastic differential equation (SDE) in probability theory, we calculate the probabilities that the nominal exchange rates reach the boundaries of the target zones for the first time, and the mean time that the nominal exchange rates remain in the target zones. Furthermore, using our explicit expressions of the fundamental factor and the defnite relationships between the variables, we analyze the effects on the probabilities from macroeconomic and non-economic factors, such as the elasticity of the premium rate of exchange rates, the fundamental factor, and the volatilities of the shocks.