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.

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Keywords EMS, exchange rates, target zones
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Koedijk, C.G., Stork, Ph.A., & de Vries, C.G.. (1998). An EMS target zone model in discrete time. Journal of Applied Econometrics, 31–48. doi:AID-JAE458%3E3.0.CO;2-F