Abstract
A discrete time approximation is derived from the standard continuous time target zone model which possesses all the key features of the continuous time version. The model allows for explicit incorporation of the stylized facts on intra-EMS exchange rate behaviour, as well as the mean-reversion effect. Realignment probabilities of the exchange rates versus the Deutsch mark of the six initial members of the EMS are calculated. The strength of the method is evaluated by comparing the realignment probabilities to the opinion of the news media around realignment days. As a second means of evaluation a number of investment strategies is run which use the realignment probabilities as a decision rule to get in and out of the EMS money market. It is shown that the investment strategy relying on the model with conditional heteroskedasticity renders higher excess returns than the model with a constant variance assumption.
Previous drafts of this paper have been presented in seminars at Erasmus Universiteit Rotterdam, Rijksuniversiteit Limburg, K.U. Leuven, CORE, the ESEM in Cambridge 1991, CentER, ZEW, and the Kniedag. We are grateful for comments and suggestions by Roel Beetsma, Harris Dellas, Paul De Grauwe, Frank de Jong, Theo Nijman, Peter Schotman, Peter Vlaar and an anonymous referee. Work by the second author was supported through grant 450-229-006 by the Dutch NWO and the third author benefitted from grant IUAP26 of the Belgian Government.
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Koedijk, B.K.G., Stork, P.A., de Vries, C.G. (1994). Stylized Facts, Realignments and Investment Strategies in the EMS. In: Kaehler, J., Kugler, P. (eds) Econometric Analysis of Financial Markets. Studies in Empirical Economics. Physica-Verlag HD. https://doi.org/10.1007/978-3-642-48666-1_11
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