A term-structure model of international interest rate convergence prior to moentary union

Wilfling Bernd

Abstract
The process of international interest rate convergence for arbitrary terms (represented by the term structure of interest rate differentials) is derived in a model of a small open economy which faces a purely time-contingent exchange rate regime switch from flexible to fixed rates. Special attention is paid to a situa-tion in which financial markets deem a delay in the regime switch beyond the publicly announced fixing date possible. The closed-form solution of the term structure allows us to analyze the volatility of interest rate differentials thus pro-viding a useful tool for interest-rate-sensitive security valuation and other risk management applications. Furthermore, the model demonstrates that the economy under consideration has to pay for the exchange rate stabilization triggered by the announcement of future regime switching by a higher uncertainty in the evolution of domestic interest rates.

Keywords
Exchange-rate regime switches; interest rates; term structure; stochastic processes; uncertainty