The Expected Timing of EMS Realignments: 1979-83

This paper develops and estimates a model of the time at which market participants expected the French franc to be devalued relative to the German deutschemark during the early years of the European Monetary System. The model assumes that the expected time of exchange rate realignment is determined by the time at which foreign exchange reserves in the Banque de France first fall below a critical threshold level, and that reserves are a Brownian motion process with a drift that depends on current economic conditions. Thus, the probability distribution for the time of the next realignment is an Inverse Gaussian distribution. The empirical analysis uses the term structure of forward exchange rate premia to form indicators of perceived probabilities of realignment over various time horizons. The model fits quite well, especially prior to the March 1983 realignment. The estimation suggests that the expected timing of realignments was quite sensitive to the level of reserves in France and to factors that affect the mean rate of change of reserves.