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. The model is tested for its S-shape and stochastic properties. To measure the degree of credibility of the EMS zone we calculate realignment probabilities and use the model to develop investment strategies which are compared with the simple random walk buy and hold strategy