Working Paper: CEPR ID: DP1307
Authors: Zsolt Darvas
Abstract: After the introduction of a preannounced crawling peg exchange rate regime in Hungary in March 1995, forward and futures rates of more than six months maturity exceeded the upper edge of the projected target zone of the Forint. This paper examines whether this fact reflects an additional devaluation expectation or whether it might be attributed to other factors, e.g. risk aversion or market inefficiency. Though in recent years the average premium on Forint assets was close to zero, past performance of the interest rate differential, as an indication of exchange rate movements, was poor; there is no real cointegrating relationship to be found. By calculating implicit probabilities of additional devaluations for the present situation, the conditions of risk neutrality and rational expectations can be rejected because the implied probabilities seem to be 'too large'. The main conclusion of the paper is that uncovered interest parity does not hold for the present Hungarian foreign exchange market; forward rates falling outside the projected band do not necessarily reflect lack of credibility in exchange rate policy.
Keywords: credibility; risk premia; uncovered interest parity; peso problem; target zone; emerging markets
JEL Codes: E43; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Crawling peg exchange rate regime (F31) | Forward and futures rates (G13) |
| Crawling peg exchange rate regime (F31) | Market inefficiencies (G14) |
| Uncovered interest parity does not hold (F31) | Disconnect between interest rate differentials and actual exchange rate movements (F31) |
| Institutional environment and market inefficiencies (O17) | Behavior of forward rates and interest differentials (E43) |
| Average premium on forint assets close to zero (G19) | Lack of risk premia demanded by investors (G19) |