Working Paper: NBER ID: w3374
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 modeled 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. Some implications of the theory are found to be broadly consistent with data on Swedish exchange rates and interest differentials for the period 1986-1989.
Keywords: Interest Rate Differentials; Target Zone; Exchange Rate Regime; Swedish Data
JEL Codes: E43; F31; F33
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) | absolute value of interest rate differential (E43) |
| time to maturity (C41) | instantaneous variability of interest rate differential (E43) |
| devaluation/realignment risks (F31) | interest rate differential (E43) |