Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models

Abstract

This paper proposes a tractable and realistic nonlinear model of exchange rate dynamics, and argues that its predictions are consistent with available empirical evidence on exchange rate and interest differential behavior in real-life target zones. In our model, the exchange rate fluctuates between given boundaries for random lengths of time and jumps discretely when devaluations occur. We allow for stochastic variability in the likelihood and size of devaluations, and we provide explicit solutions for the stochastic processes followed by the exchange rate and by the expected rate of depreciation. The model produces realistic patterns of covariation between exchange rates and interest rate differentials, and provides interesting interpretations of available empirical evidence. We also specify how to infer devaluation risk from target zone data.