Exchange Rate Expectations, the Forward Exchange Rate Bias and Risk Premia in Target Zones

Marianne Nessen ()

No 14, SSE/EFI Working Paper Series in Economics and Finance from Stockholm School of Economics

Abstract: A method proposed by Bertola and Svensson (1993) is used to extract expected rates of depreciation within the target zone band for four Nordic currencies 1979-1989. These are then combined with time-series of expected rates of devaluation (defined as changes in central parities of the target zones) estimated by Edin and Vredin (1993). The result is time-series of the overall expected change in the exchange rate for the four currencies. Using these we can residually construct time-series of the foreign exchange risk premium and expectational errors. We find substantial and time-varying risk premia, why we question the widely used practice of assuming that UIP holds, e.g. when studying the credibility of target zone regimes. The estimated time-series of risk premia and expectational errors are used to attribute the forward exchange rate bias to expectational errors and/or risk premia, following a decomposition derived in Froot and Frankel (1989). We conclude that for the four Nordic countries studied in this paper - Denmark, Finland, Norway and Sweden - time-varying risk premia appear to be the dominant cause of deviations from UIP, while the role of expectational errors is less clear.

Keywords: Devaluation expectations; target zones; risk premia (search for similar items in EconPapers)
JEL-codes: F31 F33 (search for similar items in EconPapers)
Pages: 37 pages
Date: 1994-04
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Published in Open Economies Review, 1997, pages 1-38.

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Persistent link: https://EconPapers.repec.org/RePEc:hhs:hastef:0014

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