Conditional Volatility of Exchange Rates Under a Target Zone

Abstract

To study the impact of institutional features of target zones on the conditional volatility of exchange rates, this paper proposes a simple and intuitive model to incorporate the announced information in the bands. Observing the statistical characteristics of the EMS cross rate returns- mean reversion and heteroskedasticity, we t a GARCH(1,1)- MA(1) speci cation incorporating the deviation of exchange rates from the central parity. This model allows us to easily examine the relationship between the conditional volatility and the position of spot rates. We nd in particular, that for the Irish punt and Italian lira DM rates, the conditional volatility increases as the exchange rate approaches the edges of the band. We extend the above univariate model to a multivariate setting to take account of the cross country interactions in the EMS, by including a vector consisting of all EMS currencies' positions in the GARCH equation. The estimation results show that other currencies' positions do a ect the conditional volatility of a speci c EMS currency. Understanding the importance of intra-ERM coherence and the multilateral commitment on the central parity, we follow Pill(1994) to derive an \e ective band" model to examine how the multilateral grid affects the conditional volatility. However, the estimation results suggest that the full set of all deviations from ocial central parity of each member country explains the volatility better than does simply the deviation from the effective band.

JEL Classification: F31, C32