This paper provides empirical support for the second generation of target zone models with stochastic devaluation risk. I propose a simple non-linear framework with a time varying probability of exchange rate realignment. This model nests alternatives (i) with no devaluation risk; (ii) with constant devaluation risk; and (iii) the random walk. I reject these three in favor of a stochastic realignment model where devaluation risk varies with economic fundamentals. The model predicts 13 of 17 realignments for the Franc and Lira, including an out-of-sample episode in August 1993.
All Science Journal Classification (ASJC) codes
- Economics and Econometrics