A jump diffusion model for the European monetary system

We propose a general continuous time bivariate jump-diffusion representation for the exchange rates of European currencies. Our model captures key features of the exchange rate mechanism. Fluctuation within bilateral limits is modeled by appropriate diffusion dynamics, while discontinuous variation in the level of the fluctuation band is posited to have a jump structure. Under specific assumptions, the probability distribution of the exchange rate process is derived analytically. We also perform an empirical investigation of these exchange rates. Comparing the fit of alternative models, we find some evidence of mean reversion inside the bands for these exchange rates. (JEL F33, C51). © 1993.