ERM BANDWIDTHS FOR EMU AND AFTER - EVIDENCE FROM FOREIGN-EXCHANGE OPTIONS

Are the wide bands adopted in the summer of 1993 too large? The offici al answer is that wide bands offer a protection against speculative pr essure, while exchange rates may be kept within narrower margins at th e discretion of the authorities. Tet if exchange rate fixity and predi ctability are desirable, ar implicitly assumed by the mere existence o f the system, there must exist a trade-off-between protection against speculative pressure and predictability. In that care, the bandwidth c hosen should be as narrow as possible and yet unlikely to be challenge d by the markets. This paper offers estimates of 'safe' bandwidths. Fo r the long-term member currencies (French franc, peseta, Danish krone and escudo), the existing 15% bands are found to be unnecessarily wide : narrower 3.5% bands would capture at least 95% of expected exchange rate realizations over a, three-month horizon. For the lira, Finnish m arkka and Swedish krone, wider bands of 5-6% would capture a similar a mount of the exchange rate distribution. The pound's exchange rate exp ectations are the most dispersed, requiring 8.4% bands to capture 95% of exchange rate expectations.