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The term structure of interest rate differentials is derived in a model of a small open economy with a target zone exchange rate regime. The target zone is modeled as a regulated Brownian motion. The interest rate differentials are computed as the solution to a parabolic partial differential equation with derivative boundary conditions, both via a Fourier-series analytical solution and via a direct numerical solution. Several specific properties of the term structure of interest rate differentials are derived. For instance, for given time to maturity the interest rate differential is decreasing in the exchange rate, and for given exchange rate the interest rate differential's absolute value and its instantaneous variability are both decreasing in the time to maturity. Devaluation/realignment risks are incorporated and imply upward shifts of the interest rate differentials. Some implications of the theory are found to be broadly consistent with data on Swedish exchange rates and interest differentials for the period 1986-1989.
This is an extensive study concerned with the potential effects of fiscal policy on financial markets in the EU. It takes into account the gradual liberalization of capital movements through Western Europe & the framework of the European Monetary System.
This edited volume examines capital mobility in both industrialised and developing countries.
An empirical model of time-varying realignment risk in an exchange rate target zone is developed. Expected rates of devaluation are estimated as the difference between interest race differentials and estimated expected rates of depreciation within the exchange rate band, using French Franc/Deutsche Mark data during the European Monetary System. The behavior of estimated expected rates of depreciation accord well with the theoretical model of Bertola-Svensson (1990) . We are also able to predict actual realignments with some success.