Front Matter Page

Research Department

Contents

• Summary

• I. Introduction

• II. Model of Expected Rates of Devaluation

• III. Estimates of Expected Rates of Depreciation within the Band

• IV. Estimates of Expected Rates of Devaluation

• V. Conclusions

• Tables

• 1. Realignment Dates and Bilateral Central DM Rates in the EMS

• 2. Expected Future Exchange Rate within the Band, (3.2)

• 3. Expected Exchange Rate Depreciation within the Band, (3.1)

• Figures

• 1-4

• 5

• References

Summary

In order to evaluate the exchange rate cooperation embodied in the Exchange Rate Mechanism (ERM) within the European Monetary System, it is important to be able to measure how much credibility financial markets find in the system. An essential aspect of this credibility is the market’s expectation of future realignments.

This paper uses a simple, operational method to estimate market expectations of future realignments against the deutsche mark (DM) for the six original non-German currencies in the ERM, using data from March 1973 (the start of the cooperation) to May 1990. A frequently used “naive” measure of market expectations of future realignment of an ERM currency against the DM is the currency’s interest rate differential to the DM, the difference between (say) a Euro interest rate for the currency in question and a Euro interest rate for the DM for a given maturity. A problem with that measure is that the interest rate differential is affected not only by the possibility of a realignment but also by the possibility of exchange rate movements within the bilateral ERM bands. For instance, a movement of the bilateral exchange rate from the center to the edge of a ±2.25 percent band in three months corresponds to an annualized rate of return of more than 9 percent a year. Hence, expected capital gains and losses owing to exchange rate movements within ERM bands can easily be of a magnitude equal to, or even greater than commonly observed interest rate differentials.

A recent study suggests that more precise measures of realignment expectations can be constructed if interest rate differentials are adjusted by subtracting econometric estimates of the expected currency depreciation within the exchange rate band. This is the method used in the present paper.

A necessary step in the method is to estimate and forecast exchange movements inside the exchange rate bands. Since (in contrast to exchange rate movements under a free float) exchange rate movements within exchange rate bands can be shown to be very regular and display strong reversion toward the center of band, the required estimation of expected rates of currency depreciation within the exchange rate band is easily done by standard econometric techniques.

The resulting estimates of expected rates of realignment can be conveniently illustrated in graphs. The actual adjustment of the interest rate differentials is indeed often of the same magnitude as the interest rate differentials themselves, which indicates that the adjustment is essential for a precise estimation of realignment expectations.