The foreign exchange risk premium in a target zone with devaluation risk

Abstract

The foreign exchange risk premium in an exchange rate target zone is derived, when the exchange rate is heteroskedastic within the band and there is a separate devaluation risk. The risk premium is then the sum of two separate risk premia, arising from uncertainty about exchange rate movements within the band and from uncertainty about devaluations. Both real and nominal risk premia are considered. Real and nominal risk premia from movements within the band are very small. Real and nominal risk premia from devaluations are larger but still relatively small proportions of the interest rate differential.