The effect of interventions on realignment probabilities

The expected future change of the exchange rate within its currency band and the expected realignment rate are estimated using the Regime–Switching Model. There exists an unobserved variable s_t, which characterises the equilibrium state of the expected future change of the exchange rate within its currency band at any time t with certain probabilities. Different values of s_t correspond to states with high and low risk of realignment, respectively. The probabilities of switching between one regime and another depend on central bank intervention in the foreign exchange market. Daily data on intervention by Norges Bank are used. The data contain relatively few actual realignments, and the sample distribution of realignments may not be representative enough to capture the discrete changes in the exchange rate caused by a non-zero subjective probability of realignment (even when no realignment has in fact taken place). This causes the very well known peso problem in the estimation.