NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk

Lars E.O. Svensson

NBER Working Paper No. 3466
Issued in October 1990
NBER Program(s):   ITI   IFM

The foreign exchange risk premium in an exchange rate target zone regime with devaluation/realignment risks is derived. In contrast to previous literature, the exchange rate's heteroscedasticity within the bard, as well as a separate devaluation/realignment risk, is taken into account. The risk premium is then the sum of two separate risk premia, arising from stochastic exchange rate movements within the bard and from stochastic devaluations/realignments when the band is shifted. Both real and nominal exchange rate premia are considered. The real and nominal risk premia from movements within the band are very small for narrow target zones and can therefore be disregarded. The real and nominal risk premia from devaluations/realignments are larger but still relatively small proportions of the expected rate of devaluation/realignment.

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Document Object Identifier (DOI): 10.3386/w3466

Published: Journal of International Economics, Vol 33, 1992. pp. 21-40 citation courtesy of

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