Pricing Currency Risk under Currency Boards
Sergio L. Schmukler
World Bank - Development Research Group (DECRG)
World Bank - Office of the Chief Economist
Journal of Development Economics, Vol. 69, No. 2
Currency risk is one of the two components of the total interest rate differential. Hard pegs, such as currency boards, are meant to reduce or even eliminate currency risk, thus, reducing domestic interest rates. This paper investigates the patterns and determinants of the currency risk premium in two currency boards - Argentina and Hong Kong. Despite the presumed rigidity of currency boards, the currency premium is almost always positive and at times very large. Its term structure is usually upward sloping, but flattens out or even becomes inverted at times of turbulence. The premium and its term structure depend on domestic and global factors related to devaluation expectations and risk perceptions.
Keywords: Currency risk, Currency premium, Forward discount, Currency board, Term structure, Covered interest parity, Market segmentation, Financial crises
JEL Classification: F31, F36, G12, G15Accepted Paper Series
Date posted: February 19, 2003
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