The options-based model of target zone and its application to the French franc

Abstract

This article develops an options-based model of the target zone arrangements. The exchange rate in a target zone is modeled as an exchange rate in a floating regime adjusted by the price of two options. The article provides an accurate description of the options, which can capture the joint effect of the edges of the band. As an application of the model, the French band widening in 1993 is analyzed. It is found that the band widening was anticipated by the market. © 2010 Macmillan Publishers Ltd.