Target Zones and Realignment Risk: An Integrated Approach

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SummaryIn this paper, it is shown that inflation differentials and trade deficits were significant determinants for exchange rate movements in the European monetary system. Since the target zone prevents EMS exchange rates from adjusting gradually to changing economic conditions, a standard regression model cannot detect this influence however. Therefore, a new econometric model is introduced, in which deteriorating competitiveness increases the probability of large depreciations and high volatility. These depreciations can be due to large devaluations or to panic reactions of the market due to expected devaluations. It is shown that the out-of-sample predictions of the model outperform the random walk, and that large arbitrage gains can be made in the foreign exchange market if our model predictions are used.

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