Working Paper: CEPR ID: DP494
Authors: Lars E. O. Svensson
Abstract: The foreign exchange risk premium in an exchange rate target-zone regime with devaluation/realignment risks is derived. In contrast to previous literature, the exchange rate's heteroscedasticity within the band, as well as a separate devaluation/realignment risk, is taken into account. The risk premium is then the sum of two separate risk premia, arising from stochastic exchange rate movements within the band and from stochastic devaluations/realignments when the bank is shifted. Both real and nominal exchange rate premia are considered. The real and nominal risk premia from movements within the band are very small for narrow target zones and can therefore be disregarded. The real and nominal risk premia from devaluations/realignments are larger but still relatively small proportions of the expected rate of devaluation/realignment.
Keywords: risk premium; foreign exchange; exchange rates; devaluation; realignment; target zones
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate movements within the band (F31) | risk premium (G19) |
| devaluation risks (F31) | risk premium (G19) |