Unique Fundamental Dynamics of Target-zone Exchange Rates

26 Pages Posted: 12 Aug 2019

See all articles by Chi-Fai Lo

Chi-Fai Lo

The Chinese University of Hong Kong

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Hei Liu

The Chinese University of Hong Kong (CUHK)

Date Written: August 8, 2019

Abstract

We have provided a rigorous derivation of the asymmetric mean-reverting fundamental dynamics proposed by Lo and coworkers (2015) for target-zone exchange rates, and have shown that the proposed fundamental dynamics is the unique choice and described by the Rayleigh process. By analogy, such a fundamental can be treated as a one-dimensional overdamped Brownian particle moving in a logarithmic-harmonic potential well. In addition, we have demonstrated that the predicted exchange rate distributions can take several different shapes, which may correspond to possible realignments and widely different (marginal and intra-marginal) intervention policies. The shapes of these distributions represent the predicted distributions discussed in previous theoretical models which only generate one or two shapes. Moreover, we have succeeded in performing explicit calibration of the proposed fundamental dynamics, thus confirming the validity of our model. Unlike the Krugman model, our model is capable of explaining the empirical observations that the exchange rate dynamics is sticky near the edges of the band, and that both positive and negative interest rate differentials can appear in the entire target zone.

Keywords: Exchange rate dynamics, target zones, interventions, stochastic processes

JEL Classification: F31, G13

Suggested Citation

Lo, Chi-Fai and Hui, Cho-Hoi and Liu, Chi-Hei, Unique Fundamental Dynamics of Target-zone Exchange Rates (August 8, 2019). Available at SSRN: https://ssrn.com/abstract=3434183 or http://dx.doi.org/10.2139/ssrn.3434183

Chi-Fai Lo (Contact Author)

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Hei Liu

The Chinese University of Hong Kong (CUHK) ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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