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Can one hear the shape of a target zone?

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Document pages: 32 pages

Abstract: We develop an exchange rate target zone model with finite exit time andnon-Gaussian tails. We show how the tails are a consequence of time-varyinginvestor risk aversion, which generates mean-preserving spreads in thefundamental distribution. We solve explicitly for stationary and non-stationaryexchange rate paths, and show how both depend continuously on the distance tothe exit time and the target zone bands. This enables us to show how centralbank intervention is endogenous to both the distance of the fundamental to theband and the underlying risk. We discuss how the feasibility of the target zoneis shaped by the set horizon and the degree of underlying risk, and wedetermine a minimum time at which the required parity can be reached. We provethat increases in risk after a certain threshold can yield endogenous regimeshifts where the "honeymoon effects " vanish and the target zone cannot befeasibly maintained. None of these results can be obtained by means of thestandard Gaussian or affine models. Numerical simulations allow us to recoverall the exchange rate densities established in the target zone literature.

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