TARGET ZONES AND EXCHANGE-RATES - AN EMPIRICAL-INVESTIGATION

This paper develops an empirical model of exchange rates in a target z one. The distribution of exchange rate changes is conditioned on a lat ent jump variable where the probability and size of a jump vary over t ime as a function of financial and macroeconomic variables. When there is no jump, the target zone is credible and exchange rate changes are constrained to remain within the target zone band. The paper revisits the empirical evidence from the European Monetary System regarding th e conditional distribution of exchange rate changes, the credibility o f the system, and the size of the foreign exchange risk premia. In con trast to some previous findings, we conclude that the French Franc/Deu tschmark rate exhibits considerable nonlinearities, realignments are s omewhat predictable, and the credibility of the system did not increas e substantially after 1987. Moreover, our model implies that the forei gn exchange risk premium becomes large during speculative crises. (C) 1998 Elsevier Science B.V.