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The author is grateful to Michael Artis, Leonardo Bartolini, Tamim Bayoumi, Francesco Caramazza, Peter Clark, Jeffrey Frankel, Ioannis Halikias, Paul Masson, Mark Taylor, and George Tsibouris for comments and to Susanna Mursula for excellent research assistance.
The exchange rate is measured as units of domestic currency per unit of foreign currency.
In target-zone currencies the large change in fundamentals may be represented by a change in the central parity.
st is measured as units of domestic currency per unit of foreign currency.
This behavior is called the honeymoon effect.
The example they give is that the probability that the central bank will realign at a pre-specified intervention point is greater than 0.5.
In this analysis τ is a 90-day period.
As there is no way of knowing whether the conditional expectation changed during the period, this assumption seems reasonable. Chen and Giovannini avoid the problem of evaluating a conditional expectation by using the change in the exchange rate as their measure of expected depreciation. They argue that the sample of observations is conditional on both realignment and no-realignment possibilities so that it is not possible to isolate one or the other.
Each quarter has approximately 65 observations because weekends are ignored.
The depreciation of the exchange rate within the band may also be influenced by macroeconomic fundamentals. These have not been included in the estimation because the equation is estimated on daily exchange rate data whereas the frequency for the macroeconomic variables is quarterly.
This is a three-month average of the daily interest rate differential.
It has been argued (Goldstein, et al., 1993) that the large capital inflow and resulting increase in net foreign assets in Italy over 1987-91 reflected an overestimation of exchange rate risk as measured by interest rate differentials. However it is not clear why lenders and borrowers would have differing opinions as to the likelihood of devaluation to warrant this premium. A test of this supposition was carried out by including a dummy for the period 1988:1 to 1991:1 (during which time there was a large increase in the net capital flow into Italy) as an explanatory variable in the Italian equation. The dummy was insignificant indicating no overestimation of devaluation risk by the market at this time.
A regression of the band position variable on the macroeconomic fundamentals indicates that it is weakly correlated with all variables except for the change in foreign exchange reserves with which it is significantly negatively related.