Target-zone rearrangement and exchange-rate behaviour 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 to 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 valuation of them. Within that 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. The author applies this options-based model to analyse 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 to the final conversation rate in the EMU, and (c) changing uncertainty.