The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data
1990 (English)Report (Other academic)
The term structure of interest rate differentials is derived in a model of a small open economy with a target zone exchange rate regime. The target zone is modeled as a regulated Brownian motion. The interest rate differentials are computed as the solution to a parabolic partial differential equation with derivative boundary conditions, both via a Fourier-series analytical solution and via a direct numerical solution. Several specific properties of the term structure of interest rate differentials are derived. For instance, for given time to maturity the interest rate differential is decreasing in the exchange rate, and for given exchange rate the interest rate differential's absolute value and its instantaneous variability are both decreasing in the time to maturity. Devaluation/realignment risks are incorporated and imply upward shifts of the interest rate differentials. Some implications of the theory are found to be broadly consistent with data on Swedish exchange rates and interest differentials for the period 1986-1989.
Place, publisher, year, edition, pages
Stockholm: IIES , 1990. , 57 p.
Seminar Paper / Institute for International Economic Studies, Stockholm University, ISSN 0347-8769 ; 466
term structure, interest rates, target zones, exchange rates, realignment, regulated Brownian motion, devaluation risks
IdentifiersURN: urn:nbn:se:su:diva-41769OAI: oai:DiVA.org:su-41769DiVA: diva2:337712