Exchange Rate Premia and the Credibility of the Crawling Target Zone in Hungary

After the introduction of a preannounced crawling peg exchange rate regime in Hungary in March 1995, forward and futures rates of more than six months maturity exceeded the upper edge of the projected target zone of the Forint. This paper examines whether this fact reflects an additional devaluation expectation or whether it might be attributed to other factors, e.g. risk aversion or market inefficiency. Though in recent years the average premium on Forint assets was close to zero, past performance of the interest rate differential, as an indication of exchange rate movements, was poor; there is no real cointegrating relationship to be found. By calculating implicit probabilities of additional devaluations for the present situation, the conditions of risk neutrality and rational expectations can be rejected because the implied probabilities seem to be 'too large'. The main conclusion of the paper is that uncovered interest parity does not hold for the present Hungarian foreign exchange market; forward rates falling outside the projected band do not necessarily reflect lack of credibility in exchange rate policy.