Abstract
November 11, 2003
Naszódi Anna (MNB)
Target zone shifts and exchange rate behavior
A shift in an exchange rate target zone presumably has an effect on the exchange rate. In this paper we develop an options based model of target zone arrangements and apply it to exchange rate band shifts of Hungary, Denmark, France and Portugal to decompose exchange rate changes into (a) the direct effect of the band shift, (b) changing expectations, and (c) changing uncertainty. In the model the exchange rate in a target zone system is equivalent to the exchange rate of a currency in an underlying freely floating system adjusted by the price of two options. The strike values of the options are the limits of the band, therefore the direct effect of the band-shift on the exchange rate can be measured by the change of the option prices caused by the change of the strike prices. The model is able to handle floating rates with future fixing, such as the EMU-entry of most of the currencies we study.