Realignment Risk Research Articles

Fixed exchange rates with escape clauses: The political determinants of the European Monetary System realignments

This paper studies the political economy of realignments to fixed exchange rates and suggests that the use of realignments is less likely when there are political benefits from stable exchange rates and when linkages across other issue areas increase the costs of realignment. More specifically for the case of the European Monetary System (EMS), the expectation is that realignments are related to partisanship, support for the broader European integration, trade integration, resource transfers from the European Community, as well as countries reacting to the political and economic costs of realignment in other EMS members. Hypotheses are tested using binomial logit models on monthly data on exchange rate realignments for all EMS countries from 1979 to 1993. I find lower realignment risk for left wing policy-makers and countries with more trade links to Germany, whereas more intra-European Community resource transfers appear to go to countries facing higher realignment risk. Also, realignments are less likely when the rest of EMS member countries have stable international reserves and their governments are pro-European.

DERIVATIVE PRICING BASED ON THE EXCHANGE RATE IN A TARGET ZONE WITH REALIGNMENT

We propose a tractable model for the exchange rate in a target zone with realignment. The target zone exchange rate dynamics is assumed to obey a bounded regular diffusion with two-sided unattainable barriers. The realignment is modeled as a continuous-time two-state Markov chain. Under the stationary setting of the Markov chain, a general pricing formula for the derivative written on the exchange rate is derived in the presence of the realignment risk. The Jacobi diffusion model is studied as an example and numerical results are presented for illustration.

P01-115 - Adolescence and addiction

Adolescence and addiction are two different entities. Adolescence is a period characterized by a realignment risk of psychic structures, physiological and morphological. It is constructed using a reference model via the values inherited from the parents and new behaviors including consumption of drug abuse “addiction”.We illustrate our presentation with a literature review done on the PubMed database using keywords such as “adolescent, addiction, neurobiologic,pathogenesis, treatment” to study all the parameters that explain the link between adolescence and addiction from a causal model neurobiology and pathophysiology to develop in a particularities of the therapeutic management of drug abuse among adolescents.

A note on estimating realignment probabilities – A first-passage-time approach

This paper proposes a path-dependent approach for estimating realignment probabilities of targeted exchange rates based on first-passage-time distributions instead of the commonly used path-independent approach. We consider that path dependency is an intrinsic characteristic of realignment risk because a realignment of an exchange rate can occur whenever a committed band by a central bank is breached. A mean-reverting lognormal process is considered in the first-passage-time approach. Based on market data of the British pound and mark during the ERM crisis of 1992, the realignment probabilities of the pound estimated under the proposed approach show that path dependency is quantitatively significant, compared with the path-independent approach.

Using First-Passage-Time Density to Assess Realignment Risk of a Target Zone

This paper proposes a path-dependent approach for estimating realignment probabilities of targeted exchange rates based on the first-passage-time (FPT) density instead of the commonly used path-independent approach. We consider that path dependency is an intrinsic characteristic of realignment risk because a realignment of an exchange rate can occur whenever a committed band by a central bank is breached. A mean-reverting lognormal process is considered in the FPT approach. Based on market data of the British pound and Italian lira during the ERM crisis of 1992, the realignment probabilities of the currencies estimated under the proposed approach show that path dependency is quantitatively significant, compared with the path-independent approach. The first-hitting time and the time of the maximum slope of the FPT density have forward-looking capability of assessing realignment risk of the pound and lira target zones.

Closed-form likelihood approximation and estimation of jump-diffusions with an application to the realignment risk of the Chinese Yuan

This paper provides closed-form likelihood approximations for multivariate jump-diffusion processes widely used in finance. For a fixed order of approximation, the maximum-likelihood estimator (MLE) computed from this approximate likelihood achieves the asymptotic efficiency of the true yet uncomputable MLE as the sampling interval shrinks. This method is used to uncover the realignment probability of the Chinese Yuan. Since February 2002, the market-implied realignment intensity has increased fivefold. The term structure of the forward realignment rate, which completely characterizes future realignment probabilities, is hump-shaped and peaks at mid-2004. The realignment probability responds quickly to economic news releases and government interventions. r 2007 Elsevier B.V. All rights reserved.

An heterogeneous expectations target zone model

This paper studies the credibility of a target zone considering the existence of heterogeneous expectations in the foreign exchange market. In general, we consider two types of agents: credible and non-credible agents (i.e. fundamentalists). One of the main results of the model is the possibility of collapse of a target zone as a function of expectations. This implies the existence of an endogenous realignment risk.

Misalignments of real exchange rates and the credibility of nominal currency bands

Misalignments of Real Exchange Rates and the Credibility of Nominal Currency Bands. — This paper analyzes a sticky-price target zone model in which realignment risk is modeled endogenously as a function of the degree of real exchange rate misalignments. The implications of the model are used to investigate the credibility of selected nominal ERM exchange rate bands. We find that a lack of credibility of the ERM currency bands occurs mostly in countries with substantial swings and persistent misalignments of real exchange rates. These findings suggest that the major real appreciations in some European bilateral real exchange rates between 1987 and 1992 have been pivotal in triggering the ERM currency crises of 1992 and 1993.

Exchange rate target zone models: a Bayesian evaluation

This paper develops a Bayesian approach to estimating exchange rate target zone models and rational expectations models in general. It also introduces a simultaneous-equation target zone model that incorporates stochastic realignment risk. Using FF/DM and IL/DM exchange rate data, we find that the signing of the 1987 Basle–Nyborg Agreement reduces both the magnitude and the likelihood of a central parity realignment, while the lagged exchange rate deviation from its central parity increases them. Furthermore, the interest rate policies and the monetary conditions of the participating countries signal a forthcoming realignment. In general, we are unable to improve upon a simple random walk model in out-of-sample exchange rate prediction by introducing target zone models. Copyright © 1999 John Wiley & Sons, Ltd.

Exchange Rate Target Zone Models: A Bayesian Evaluation

This paper develops a Bayesian approach to estimating exchange rate target zone models and rational expectations models in general. It also introduces a simultaneous-equation target zone model that incorporates stochastic realignment risk. Using FF/DM and IL/DM exchange rate data, we find that the signing of the 1987 Basle-Nyborg Agreement reduces both the magnitude and the likelihood of a central parity realignment, while the lagged exchange rate deviation from its central parity increases them. Furthermore, the interest rate policies and the monetary conditions of the participating countries signal a forthcoming realignment. In general, we are unable to improve upon a simple random walk model in out-of-sample exchange rate prediction by introducing target zone models.

ERM Realignment Risk and its Economic Determinants as Reflected in Cross‐rate Options

This paper uses data on over-the-counter options between the mark and the pound, lira, French franc, and peseta to investigate the credibility of exchange rate target zones within the ERM. We compare empirical implications for the relation between option prices and the spot's position within the band for three classes of target zone models: those with full credibility, those with exogenous realignment risk, and those with endogenous realignment risk. Empirically, implied volatility from these options attains a maximum near the edges of an exchange rate band rather than its centre, even three to six months prior to realignment.

Implied exchange rate distributions: evidence from OTC option markets

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.

Target Zones and Realignment Risk: An Integrated Approach

In this paper, it is shown that inflation differentials and trade deficits were significant determinants for exchange rate movements in the European monetary system. Since the target zone prevents EMS exchange rates from adjusting gradually to changing economic conditions, a standard regression model cannot detect this influence however. Therefore, a new econometric model is introduced, in which deteriorating competitiveness increases the probability of large depreciations and high volatility. These depreciations can be due to large devaluations or to panic reactions of the market due to expected devaluations. It is shown that the out-of-sample predictions of the model outperform the random walk, and that large arbitrage gains can be made in the foreign exchange market if our model predictions are used.

Inflation differentials and excess returns in the European Monetary System

The dynamics of weekly excess returns of an investment in a foreign currency against that in the D-Mark are studied for four EMS currencies. For most of the period 1979–1990, the interest differentials within the EMS have been higher than the realized depreciations relative to the D-Mark. Two explanations for the existence of excess returns are found. The first is uncertainty, measured by the conditional standard deviation, which is influenced to a large extent by the inflation differential. The second source is the continuously changing perceived realignment risk, which causes the returns to be negatively correlated and induces a positive relationship between the returns and the position of the spot rate in the fluctuation band.

Realignment risk and currency option pricing in target zones

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.

French-German Interest Rate Differentials and Time-Varying Realignment Risk

This paper explores the determinants of realignment expectations for the French franc – deutsche mark exchange rate. Expected changes in the central parity are estimated by adjusting short-term Euromarket interest rate differentials for the expected rate of change in the exchange rate within the ERM fluctuation band and by the yield differential on long-term government bonds. The results indicate that the exchange rate within the band is mean reverting and that expected changes are sizable. Realignment expectations are found to be related to the evolution of fundamental economic variables and, for shorter horizons, the position of the franc in the fluctuation band.

French-German Interest Rate Differentials and Time-Varying Realignment Risk

This paper explores the determinants of expected rates of realignment of the French franc/Deutsche mark exchange rate during the period 1987-1991. It does so by first estimating expected parity changes and then relating these to economic variables that are believed to influence agents` realignment expectations. Time-varying expected rates of realignment are estimated in two ways: one, by adjusting short-term euromarket interest rate differentials for the expected rate of change of the FF/DM exchange rate within the EMS fluctuation band and two, by the differential in the yield on long-term government bonds. The behavior of the exchange rate within the band is found to be consistent with mean reversion and the expected change is nontrivial. Thus, by filtering out the expected mean reversion within the band from short-term interest rate differentials more precise measures of expected changes in the central parity are obtained. Realignment expectations are found to be closely related to the evolution of fundamental economic variables and, for shorter horizons, the position of the franc in the fluctuation band.

French-German Interest Rate Differentials and Time-Varying Realignment Risk

This paper explores the determinants of expected rates of realignment of the French franc/Deutsche mark exchange rate during the period 1987-1991. It does so by first estimating expected parity changes and then relating these to economic variables that are believed to influence agents’ realignment expectations. Time-varying expected rates of realignment are estimated in two ways: one, by adjusting short-term euromarket interest rate differentials for the expected rate of change of the FF/DM exchange rate within the EMS fluctuation band and two, by the differential in the yield on long-term government bonds. The behavior of the exchange rate within the band is found to be consistent with mean reversion and the expected change is nontrivial. Thus, by filtering out the expected mean reversion within the band from short-term interest rate differentials more precise measures of expected changes in the central parity are obtained. Realignment expectations are found to be closely related to the evolution of fundamental economic variables and, for shorter horizons, the position of the franc in the fluctuation band.

Expected and Predicted Realignments: The FF/DM Exchange Rate during the EMS, 1979-93

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 race 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 actual realignments with some success.

Expected and Predicted Realignments: The FF/DM Exchange Rated 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 actual realignments with some success.