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A Quasi-Bounded Target Zone Model - Theory and Application to Hong Kong Dollar

C. F. Lo, C. H. Hui, S. W. Chu and Tom Fong ()
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C. F. Lo: The Chinese University of Hong Kong and Hong Kong Institute for Monetary Research
C. H. Hui: Hong Kong Monetary Authority and Hong Kong Institute for Monetary Research
S. W. Chu: The Chinese University of Hong Kong

No 282012, Working Papers from Hong Kong Institute for Monetary Research

Abstract: The exchange rate target zone literature has often suggested that mean reversion in an exchange rate within a zone can be taken as evidence that the system is credible. While the exchange rate system in Hong Kong is perceived as having a high degree of credibility, there is mixed empirical evidence to suggest that the HKD shows mean reversion. This paper proposes a quasi-bounded process for exchange rate dynamics within a target zone, consistent with a fully credible exchange rate band in which the exchange rate cannot breach the strong-side limit while the weak-side limit is only accessible under restricted conditions of the relationship between the parameters of the drift term and stochastic part of the process. Our empirical results suggest that this model can describe the dynamics of the Hong Kong dollar where the drifting force is an increasing function of foreign reserves.

Keywords: Stochastics Process; Target Zone; Bounded Process (search for similar items in EconPapers)
JEL-codes: F31 G13 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2012-11
New Economics Papers: this item is included in nep-mon
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