Target zone rearrangements and exchange rate behavior in an options-based model

This paper sets up an options-based model of the exchange rate in a target zone system according to which the observed exchange rate is equivalent to a floating exchange rate adjusted with the value of two options. The strike prices of the options are the limits of the band, but the two options are interrelated which complicates their evaluation. Within this framework, the direct effect of the band rearrangement on the exchange rate can be measured by the change of the option prices caused by the change of the strike prices. We apply this options-based model to analyze the depreciation of the forint in the summer of 2003. Depreciation is decomposed into (a) the direct effect of the band-shift; (b) changing expectations relating the final conversation rate in the EMU; and (c) changing uncertainty. Exchange rate changes of some European currencies due to band rearrangements is also analyzed.