TY - JOUR
AU - Svensson,Lars E.O.
TI - The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data
JF - National Bureau of Economic Research Working Paper Series
VL - No. 3374
PY - 1990
Y2 - June 1990
DO - 10.3386/w3374
UR - http://www.nber.org/papers/w3374
L1 - http://www.nber.org/papers/w3374.pdf
N1 - Author contact info:
Lars E.O. Svensson
SIFR - The Institute for Financial Research
Swedish House of Finance
Stockholm School of Economics
Drottninggatan 98
SE-11160 Stockholm
Sweden
E-Mail: lars.svensson@iies.su.se
AB - 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.
ER -