Predicting Currency Crises Using the Term Structure of Relative Interest Rates: Case Studies of the Czech Republic and Russia

Among the plethora of early warning mechanisms for currency crises proposed in the literature, there is an approach which has received little attention so far. This rather simple early warning indicator relies on the term structure of relative interest rates, unlike the vast majority of such systems that are based on macroeconomic fundamentals to predict a crisis in a long- or medium-term horizon. It measures changes in market sentiment regarding the relative probability of a currency crisis to estimate the timing of a crisis within a very short time window. This indicator thus complements long-horizon models that have been widely used so far. We apply this method to currency crises in the Czech Republic in 1997 and in Russia in 1998 and fi nd evidence that the indicator would have performed well as a real-time predictor in both episodes of currency distress.