The paper proposes a stochastic model for the bilateral exchange rate of currencies participating in the European Monetary System (EMS). A bivariate jump-diffusion process is employed to represent the exchange rate and the institutional constraints affecting it. A discrete time and state model is also provided. In the model, conditional mean reverting behaviour is posited for the exchange rate. Mean reverting behaviour can actually be empirically observed for EMS exchange rates, as opposed to the usual findings for freely floating exchange rates, and constitutes evidence in favour of the model. The proposed model may find application in asset pricing models, especially currency options pricing models.
The present paper is a revised version of a manuscript presented at the 15 Annual Meeting of the European Finance Association, September 1-3 1988, Istanbul, Turkey.
