The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data

Lars Svensson

No 495, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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 modelled 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. Several implications of the theory are found to be broadly consistent with data on Swedish exchange rates and interest differentials for the period 1986-9.

Keywords: Exchange Rates; Realignment; Regulated Brownian Motion; Target Zones; Term Structure (search for similar items in EconPapers)
Date: 1991-01
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Related works:
Journal Article: The term structure of interest rate differentials in a target zone: Theory and Swedish data (1991)
Working Paper: The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data (1990)
Working Paper: The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data (1990)
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