An EMS target zone model in discrete time

The discrete time analogue of the continuous time Krugman target zone model is developed in order to capture the typical volatility clusters and fat-tailed distributed innovations of exchange rates. It is shown that under these more general stochastic conditions the S-shaped relation between exchange rate and fundamentals is preserved, but is less pronounced. The model is tested for its S-shape and stochastic properties. Two clearly distinct sets of EMS currencies are detected on the basis of the curvature features. One-step-ahead realignment probabilities are used as an alternative evaluation method. © 1998 John Wiley & Sons, Ltd.