Working Paper: NBER ID: w3466
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 bard, 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 bard and from stochastic devaluations/realignments when the band 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: foreign exchange risk premium; target zone; devaluation risk
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign exchange risk premium (F31) | expected rate of return differential (G11) |
| devaluation risks (F31) | risk premia (G22) |
| movements within the band (F20) | risk premia (G22) |
| devaluation/realignment risks (F31) | risk premia (G22) |