Working Paper: CEPR ID: DP493
Authors: Lars E. O. Svensson
Abstract: Under the assumption of no arbitrage, exchange rate target-zone credibility is tested by whether domestic interest rates fall within `rate-of-return bands' between the maximum and minimum home-currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest rate parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. Under the assumption that devaluations are a Poisson process, the expected exchange rate, the probability intensity and the expected size of a devaluation can be related. These tests are illustrated using data on the Swedish target zone between January 1987 and August 1990.
Keywords: exchange rates; target zones; credibility; devaluation risk; term structure; interest rate bands
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic interest rates (E43) | Credibility of the target zone (E61) |
| Expected future exchange rates (F31) | Credibility of the target zone (E61) |
| Domestic interest rates (E43) | Expected future exchange rates (F31) |
| Expected rate of depreciation of the krona (F31) | Credibility of the target zone (E61) |
| Interest rate differentials (E43) | Expected future exchange rates (F31) |