Working Paper: CEPR ID: DP495
Authors: Lars E. O. Svensson
Abstract: The term structure of interest rate differentials is derived in a model of a small open economy with a target-zone exchange rate regime. The target zone is modelled as a regulated Brownian motion. The interest rate differentials are computed as the solution to a parabolic partial differential equation with derivative boundary conditions, both via a Fourier-series analytical solution and via a direct numerical solution. Several specific properties of the term structure of interest rate differentials are derived. For instance, for given time to maturity the interest rate differential is decreasing in the exchange rate, and for given exchange rate the interest rate differential's absolute value and its instantaneous variability are both decreasing in the time to maturity. Devaluation/realignment risks are incorporated and imply upward shifts of the interest rate differentials. Several implications of the theory are found to be broadly consistent with data on Swedish exchange rates and interest differentials for the period 1986-9.
Keywords: term structure; interest rates; target zones; exchange rates; realignment; regulated brownian motion; devaluation risks
JEL Codes: 431; 432; 313
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate (F31) | interest rate differential (E43) |
| time to maturity (C41) | interest rate differential (E43) |
| time to maturity (C41) | variability of interest rate differential (E43) |
| devaluation/realignment risks (F31) | interest rate differential (E43) |