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The first and second authors are Economists in the European Department, International Monetary Fund. The third author is Professor of International Economics at the Institute for International Economic Studies, Stockholm University. The paper was written while the third author was Visiting Scholar in the Research Department, IMF. He thanks the Research Department for its hospitality. The authors are grateful to Adalbert Knöbl for useful comments and to Linda Galantin for research assistance. The views expressed are those of the authors and do not neeessarily represent those of the IMF.
The term “Nordic countries” refers only to Denmark, Finland, Norway, and Sweden throughout this paper.
The term “no arbitrage” is used to mean that all arbitrage opportunities have been exhausted.
Note that if the interest rates are expressed not as annualized compounded rates of return but as simple annualized rates (which is the case of the Euro-market for maturities of less than one year), equation (2) can be written
The forward exchange rates computed according to (2) are implicit forward exchange rates, derived from the interest rates. Under covered interest parity they are equal to market forward exchange rates, except for (small) transactions costs reflected in bid-offer spreads.
The coefficient of relative risk aversion is measured as the negative of the elasticity of marginal utility of consumption with respect to consumption.
Traditional tests of uncovered interest rate parity (or whether forward exchange rates are unbiased predictors of future exchange rates) which do not explicitly incorporate realignment or regime shift risk (what in the literature has sometimes been called “the Peso problem”) are not relevant to the issue of whether uncovered interest rate parity is a good approximation in exchange rate bands (see Froot and Thaler (1990)).
The second test’s sensitivity to the size of the foreign exchange risk premium is easy to examine, however, for instance by adjusting the domestic interest rate i£ in (2) for the risk premium.
For example, in Finland, “guesstimates” about the size of the liquidity premium in long-term bond rates are at around 0.7-0.8 percentage points.
For all Nordic countries, the move of the exchange rate toward the upper limit of the band implies a depreciation.
See Kontulainen, Lehmussaari and Suvanto (1990) for a thorough discussion of the Finnish exchange rate band, including its credibility.