DP6487 | Currency Crisis Triggers: Sunspots or Thresholds?

Publication Date

21/09/2007

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Abstract

If currency crises are triggered when the currency overvaluation hits a threshold, the expected magnitude of a devaluation, conditional on its occurrence, is substantially different from the unconditional expected currency overvaluation. That is not true if currency crises are triggered by sunspots. Therefore, implications for the behaviour of the probability and the expected magnitude of a devaluation depend on what triggers currency crises. Those two variables are not observable but can be estimated using data on exchange rate options. This paper identifies the probability and expected magnitude of a devaluation of Brazilian Real in the period leading up to the end of the Brazilian pegged exchange rate regime and contrasts the estimates to the predictions from a simple model of currency crises under different assumptions about the trigger. The empirical findings favour thresholds and learning over sunspots.