Testing mean reversion in target-zone exchange rates

The aim of the paper is to assess to what extent European Monetary System (EMS) target zone exchange rates have been characterized by mean reverting behaviour. To this purpose, a new class of mean reversion tests is introduced. With respect to standard approaches, the proposed tests – which are based on the sample excursion of the exchange rate within the band – have a better ability to detect target-zone mean reverting dynamics. The empirical analysis of the exchange rates among the main EMS currencies shows that the degree of mean reversion is much higher than what has been reported in the literature, both before and after the target zone widening of 1993. Finally, the proposed tests have a wider range of applications since they originate a new approach to unit root testing.