Using first-passage-time density to assess realignment risk of a target zone

C. H. Hui
*1
, C. F. Lo
2,3
, T. K. Chung
2


Abstract
This paper proposes a path-dependent approach for estimating realignment probabilities of
targeted exchange rates based on the first-passage-time (FPT) density instead of the
commonly used path-independent approach. We consider that path dependency is an
intrinsic characteristic of realignment risk because a realignment of an exchange rate can
occur whenever a committed band by a central bank is breached. A mean-reverting
lognormal process is considered in the FPT approach. Based on market data of the British
pound and Italian lira during the ERM crisis of 1992, the realignment probabilities of the
currencies estimated under the proposed approach show that path dependency is
quantitatively significant, compared with the path-independent approach. The first-hitting
time and the time of the maximum slope of the FPT density have forward-looking capability
of assessing realignment risk of the pound and lira target zones.

JEL Classification: F31, G13
Keywords: realignment risk, ERM crisis, first-passage-time probability

* Correspondence. E-mail: chhui@hkma.gov.hk Phone: (852) 2878 1485 Fax: (852) 2878 2485
1 Research Department, Hong Kong Monetary Authority, 55/F, Two International Finance Centre, 8, Finance
Street, Central, Hong Kong, China.
2 Institute of Theoretical Physics and Department of Physics, The Chinese University of Hong Kong, Shatin,
N.T., Hong Kong, China. E-mail: cflo@phy.cuhk.edu.hk
3 Hong Kong Institute for Monetary Research, Hong Kong Monetary Authority, 55/F, Two International
Finance Centre, 8, Finance Street, Central, Hong Kong, China.
2
1. Introduction
Option markets have the desirable property of being forward-looking in nature and
thus are a useful source of information for gauging market sentiment about future values of
financial assets. Options, whose payoff depends on a limited range of the expected exchange
rate, offer broader information about market expectations than the forward exchange rate.
The entire risk neutral probability density function of the exchange rate can be inferred from
the volatility implied from option prices. Several studies have used option prices to estimate
realignment risk of targeted exchange rates during the Exchange Rate Mechanism (ERM)
crisis in 1992. Malz (1996), Mizrach (1996) and Sderlind (2000) estimated the realignment
risk of the British pound exchange rate based upon its risk neutral probability density
functions for the crisis period. Campa and Chang (1996) calculated a minimum realignment
size for the exchange rate using arbitrage arguments only. The estimation of the realignment
risk has become an important measure for assessing the credibility of a target zone.
The approach used by Malz (1996) to infer the probability density function is based
on the assumption that the pound exchange rate follows the Bernouilli version of a jump-
diffusion process, postulating either one jump until option maturity or no jump at all (see Ball
and Torous, 1983, 1985). Implicitly, the estimated realignment probabilities are defined as
the likelihood that the spot pound exchange rate is below the lower band (i.e., the lower
fluctuation limit) at the end of a specified time horizon. Therefore, the estimation is
independent of the path of the exchange rate within the time horizon. Such a path-
independent approach has also been used in estimating realignment risk in Campa and Chang
(1996), Mizrach (1996) and Sderlind (2000).
This paper proposes an approach for estimating probabilities of an exchange rate
hitting a band limit of a target zone based upon a first-passage-time (FPT) approach, which is
path-dependent, instead of the commonly used path-independent approach. Such a first-
3
hitting event would trigger compulsory intervention by the central bank or a realignment of
the currency. The realignment probability (which represents a proxy for band credibility) can
thus be assessed by measuring the first-hitting probability. This paper demonstrates that there
is a significant difference between the probabilities measured by the path-independent
approach and by the FPT approach. It is because the risk measurement of the path-
independent approach depends on the exchange rate only at the end of some time interval, but
not on its particular path. This means that the path-independent realignment probability does
not take into account the risk of the exchange rate passing through the target zone boundary
during some time interval. It also implicitly assumes that hitting a band limit of the target
zone (or a realignment) can only occur at the end of the time horizon of risk assessment, and
that the exchange rate is otherwise free to move to any level relative to the band. The path-
independent approach therefore underestimates the realignment risk by an amount equal to
the probability of breaching the band during some time interval. This paper however
considers that path dependency is an intrinsic characteristic of realignment risk because a
realignment of an exchange rate can occur whenever a committed band by a central bank is
breached, that could be triggered by an important economic-political event. The FPT
approach explicitly recognises the consequences of a realignment whenever the exchange rate
falls below (or rises above) a band limit. Consequences like a readjustment of the band will
also move the targeted exchange rate of a currency.
An important prediction of the theoretical literature on targeted exchange rates is that
mean reversion of the exchange rate is expected when the central banks engage in
intramarginal intervention. Others argue that credibility of a target zone induces stability
speculation by market participants, producing forces to drag the exchange rate back to the
central parity whenever it drifts away too much from it. This mean-reverting property is
widely referred to in the literature (see for example, Krugman (1991), Svensson (1992), Rose
4
and Svensson (1994), and Anthony and MacDonald (1998)). Several recent studies have
attempted to investigate empirically this theoretical prediction by examining the time-series
properties of the currencies participating in the European Monetary System (EMS) (see for
example, Ball and Roma (1993, 1994), Svensson (1993), Rose and Svensson (1994),
Nieuwland et al. (1994), Anthony and MacDonald (1999), and Kanas (1998)). While their
investigations show mixed results, the empirical results suggest that mean reversion is present.
In view of this evidence, the exchange rate within a target zone is assumed to follow a mean-
reverting lognormal process for estimating the first-hitting probabilities in this paper.
1

With respect to the FPT probability density, this paper directly assesses the time
period until the exchange rate first hits a band limit of a target zone, i.e., the expectation of
escape time of the exchange rate from the target zone. The peak of the FPT density is used to
identify the first-hitting time. In addition, the time of the corresponding maximum slope of
the FPT density (i.e., the maximum rate of escape) is identified as a triggering point where
the exchange rate is expected to move towards the band limit of the target zone at the
maximum capacity. Such movements of the exchange rate may trigger intervention by the
central bank or even a realignment of the currency. These two measures are found to provide
forward-looking signals for the assessment of the credibility of a target zone, in particular
when the first-hitting (realignment) probability is close to zero and the target zone is
considered to be fully credible.
In the following section, we derive first-hitting probabilities under the mean-reverting
lognormal process using the FPT approach. In section 3, the first-hitting probabilities, first-
hitting time, and time of the maximum rate of escape of the pound and the lira during the
ERM crisis in 1992 are calculated from the FPT approach and the results are compared with

1
Ball and Roma (1998) indicate that the mean-reverting behaviour of the exchange rates in the EMS may be due
to the effect of reflecting barriers where the intervention boundaries are fully credible. However, this paper uses
an absorbing barrier, where the intervention boundary is not necessarily fully credible, to calculate the FPT
density.
5
those obtained from the path-independent approach. The final section summarises the
findings.

2. FPT density under mean-reverting lognormal process
Regarding the derivation of the formulas for the FPT density of a mean-reverting
lognormal process, we need to solve the Kolmogorovs backward equation governing the
transition probability density ( ) t S S p , ,
0
connecting the current spot exchange rate (i.e., the
domestic currency value of a unit of foreign currency) S
0
and the rate S at the backward time t
in the presence of two absorbing boundaries at
L
H S = and
U
H S = :
( ) ( ) ( ) { }
2
2 2 0 0 0
2
( , , ) ( , , ) ( , , ) 1
( ) ( ) ln ln *
2
p S S t p S S t p S S t
t S t t S r t r t S
t S S


= + + (


, (1)
where is the conditional mean exchange rate, is the parameter measuring the speed of
reversion to this mean, r and r* are the risk-free interest rates of the domestic and foreign
currencies respectively, and the is the volatility of the exchange rate. The FPT distribution
function (or the first-hitting probability) ( ) t S P
FP
, is given by ( , ) 1 ( , )
FP
P S t P S t , where
the transition probability distribution function
0 0
( , ) ( , , )
U
L
H
H
P S t p S S t dS

also satisfies the

backward equation with the additional boundary condition ( ) 1 0 , = S P .
Introducing the new variable ( )
L
H S x / ln , the backward equation governing ( ) t S P ,
is simplified to
( ) ( )
2
2 2
2
( , ) 1 ( , ) ( ) 1 ( , )
( ) ( )[ln ] * ( )
2 2
L
P x t P x t t P x t
t t x r t r t t
t x H x

| |
= + +
` |

\ )
. (2)
Without loss of generality, we assume that ( ) t x P , is given by
6
) ), ( )} ( exp{ (
~

) , (
~
) ( exp ) ( exp ) , (
3
3
t t x t c x P
t x P
x
t x
x
x t c t x P

=
)
`

)
`

=
(3)
where
( ) ( )
1 2
2

1 3
0

2
2 3
0

3
0
*( ) ( ) ( )
( ) ( )
( ) ( ) ln ' * ' exp{ ( )}
2
1
( ) ( ) exp{2 ( )}
2
( ) ( )
t
L
t
t
x t c t c t
t t
c t t r t r t c t dt
H
c t t c t dt
c t t dt

=
| |

= +
` |
\ )
=
=

(4)
with being a real adjustable parameter. Then it can be easily shown that ) , (
~
t x P satisfies
the partial differential equation:
x
t x P
t c t
x
t x P
t c t
t
t x P

) , (
~
)} ( 2 exp{ ) (
2
1 ) , (
~
)} ( 2 exp{ ) (
2
1 ) , (
~
3
2
2
2
3
2
. (5)
Next, defining ) (
2
t c = and { } { } ) , (
~
2 / exp 4 / exp ) , (
2
t x P x t x P = , we can cast Eq.(5) into
the canonical form of the diffusion equation
2
2
) , ( ) , (
x
x P x P

. (6)
By direct substitution, it is straightforward to show that
)
`

|
|

\
|

)
`

= ) (
exp
) (
sin
) ( 4
exp
) (
) , (
0
2 2
1
2 0 0

L L
n
L
x n
A x
L
L
L
L
x P
n
n
(7)
is the general solution of the diffusion equation for ) 1 ( ) ( 0
0
+ L L x and 0 where
0
L denotes the interval of the target zone at 0 = t , i.e., ( )
L U
H H L / ln
0
= , subject to the
absorbing boundary conditions: 0 ) , ( = x P at both 0 = x and ) ( L x = . Here is a real
adjustable parameter and A
n
s are the expansion coefficients to be determined. As a result,
the function ) , ( t x P of the corresponding boundary conditions is given by
7
( )
( ) ( )
)
`

|
|

\
|

)
`

)
`

)
`

) (
) (
exp
) (
)] ( )} ( exp{ [
sin
)] ( )} ( exp{ [
)) ( ( 4
exp
)] ( )} ( exp{ [
2
1
exp
) (
4
1
exp
) (
) , (
2 0
2
2 2
2
3
1
2
3
2
0
3
2
2
2
0
t c L L
t c n
t c L
t x t c x n
A
t x t c x
t c L
L
t x t c x
t c
t c L
L
t x P
n
n

. (8)
This function has two moving boundaries specified by
)}) ( exp{ )] ( ) ( exp([
)}) ( exp{ ) ( exp( ) (
3 2 1
3
t c t c t c H
t c t x H t S
L
L L
=
=

(9)
and
2 3
1 2 0 3
1 2 3
( ) exp([ ( ) ( ( ))]exp{ ( )})
exp([ ( ) ( ) ]exp{ ( )})
exp([ ( ) ( )]exp{ ( )})
U L
L
U
S t H x t L c t c t
H c t c t L c t
H c t c t c t

= +
= +
=
, (10)
where
0
L . It is obvious that the two real adjustable parameters and are
responsible for controlling the movement of the two boundaries.
The expansion coefficients A
n
s are determined by

4
1
2
1
exp sin
2 0
0
2
0 0

)
`

+
|
|

\
|
=
L
n
x x
L
x n
dx
L
A

. (11)
The integral in Eq.(11) cannot be evaluated in closed form and numerical quadrature is
needed for the evaluation. Nevertheless, according to our calculations the numerical
quadrature can be very efficiently performed by Mathcad running on a PC with Window 98.
Furthermore, in our calculations only the first 20 expansion coefficients are usually needed to
ensure convergency of the results.
To simulate the fixed lower and upper boundaries at
L
H S = and
U
H S =
respectively, we choose the optimal values of the adjustable parameters and so as to
minimise both of the integrals
8
2

0
( )
ln
T
L
L
S t
dt
H

| |

` |
\ )

and
2

0
( )
ln
T
U
U
S t
dt
H

| |

` |
\ )

.
In other words, we try to minimise the deviations from the fixed boundaries by varying the
parameters and . Here T denotes the time horizon. Simple algebraic manipulations then
yield the optimal vales of and as follows:

=
T
T
opt
dt t c t c
dt t c t c t c

0
3
2
2

0
3 2 1
)} ( 2 exp{ ) (
)} ( 2 exp{ ) ( ) (

+ =
T
T
opt opt
dt t c t c
dt t c t c t c
L

0
3
2
2

0
3 2 3
0
)} ( 2 exp{ ) (
)} ( 2 exp{ ) ( )}] ( exp{ 1 [
. (12)
Furthermore, we can also determine the upper and lower bounds for the exact FPT
distribution function. It is not difficult to show
2
that if the moving boundaries stay outside
the region bounded by the fixed boundaries, i.e., ( )
U U
S t H

> and
L L
H t S <

) ( , for the
duration of interest, then the corresponding value will provide a lower bound for the exact
value. On the other hand, if the moving boundaries are embedded inside the bounded region,
i.e., ( )
U U
S t H

< and
L L
H t S >

) ( , then the corresponding value will serve as an upper bound.

For constant input model parameters (i.e., , , , r
*
and r being constant), the FPT
density (or the first-hitting probability density) can be defined by ( )
( ) ,
,
FP
FP
P S t
p S t
t

,
which gives a measure of the likelihood of the exchange rate hitting a band limit of a target
zone or a realignment of the currency in a specified time horizon. Based on the derived FPT
density, the expected time for the exchange rate hitting a band (i.e., first-hitting time) can be
estimated and is roughly regarded as the duration time of the exchange rate staying within the
zone. The first-hitting time
0
is defined as:

2
The proof is based upon the maximum principle for parabolic partial differential equations (see the appendix
of Lo et al. (2003) for the relevant proof).
9

( )
(

> = 0
,
; 0
0
t
t S p
t
FP
, (13)
which is the time of the peak of the first-hitting probability density with respect to time.
3
It is
obviously noted that longer first-hitting time implies lower likelihood of the exchange rate
hitting a band limit.
Another measure of the time
1
of the corresponding maximum slope of the FPT
density (i.e., the maximum rate of escape) is used to assess the realignment risk, which is
defined as:

( )
1
,
0; max
FP
p S t
t
t

(

= >
` (

)
. (14)
1
can be interpreted as a measure of time that the exchange rate takes to move towards a
band limit of the target zone at the maximum capacity. Similar to the first-hitting time, a
larger value of
1
means a lower probability of the exchange rate hitting a band limit.

3. Estimating measures from FPT density
In this section, the three measures derived previously are employed to assess the
likelihood of the exchange rates of the British pound (GBP) and the Italian lira (ITL) against
the Deutschemark (DEM) hitting the band limits.
For the pound, the model parameters used to estimate first-hitting probabilities are
those used by Malz (1996) based upon combining the information from several options with
different strike prices covering the period from 31 March 1992 to 16 September 1992. On 16
September 1992, the pound left the ERM after a period of turbulence. The first-hitting
probabilities of the pound with a one-month time horizon based on the FPT density under the
lognormal process and the mean-reverting process respectively are shown in Figure 1. They

3
The definition is different from the mean first-hitting time which is in general quite large.
10
are calculated for each day by using the volatility implied from at-the-money DEM/GBP
option prices, as well as market data of S, r, and r*.
4
The lower band limit H
L
is DEM2.778
per GBP and the upper band limit H
U
is DEM3.122 per GBP (which put the pound into the
% 6 band). For the mean-reverting process, the conditional mean exchange rate is set at
DEM2.95 which is the central parity during the period. The speed of reversion is set to be
0.478.
5
The first-hitting probabilities estimated by the two path-dependent models based on
the FPT approach, where Eq.(8) is used, are compared with the realignment probabilities
based on the path-independent approach with a jump-diffusion process in Malz (1996).
6
For
comparison, the realignment probabilities based on the path-independent approach with a
lognormal process are illustrated in Figure 1.
Figure 1 shows that the probabilities estimated by the four models are almost zero
during most of the time from April to early July of 1992. During mid-July and early August,
their probabilities start to increase but are below 0.3 which is relatively low. The
probabilities estimated by the path-independent approach with the jump-diffusion process are
close to those estimated by the FPT approach and by the path-independent approach with the
lognormal process.
The probabilities then rise sharply in the second half of August, peaking on
September 16. The probabilities estimated by the FPT approach with both the lognormal and
mean-reverting processes, which are above 0.5 during most of the time of the period, are
substantially higher than those (about 0.4) estimated by the path-independent approach. In

4
The at-the-money option prices are provided by JPMorgan. Other market data are from Bloomberg.
5
is estimated by applying the maximum likelihood technique to the mean-reverting specification of S using
394 weekly observations of the DEM/GBP exchange rate in the period from 6 March 1985 to 15 September
1992. The corresponding estimated is DEM2.8515. It is not the objective of this paper to investigate the
mean-reverting behaviour of the exchange rates in the ERM. The estimation is just for the purpose of numerical
illustrations of the mean-reverting model.
6
It is noted that the realignment probabilities estimated in Malz (1996) only consider the realignment risk at the
lower band limit. The first-hitting probabilities estimated the realignment risk at both the upper and lower band
limits. However, the movements of the GBP exchange rate were at the side of the lower band during the study
period.
11
particular, the probabilities estimated by the FPT approach are higher than 0.7 several times
in September, while the corresponding probabilities estimated by the path-independent
approach with jump-diffusion process range only between 0.39 and 0.46. Even for the
pounds two brief respites from pressure, following the UKs announcement of plans to
borrow ECU 10 billion to defend the pound on September 3, and following the lira
devaluation on September 14, the probabilities estimated by the FPT approach with the
lognormal process are still about 0.5, while those estimated by the path-independent approach
(with the jump-diffusion process and lognormal process) are below 0.3. On 16 September
1992 when the pound left the ERM, the probabilities estimated by the FPT approach reach
almost 1, while those estimated by the path-independent approach with the jump-diffusion
are only around 0.4. The results show that the path dependency is an important characteristic
of assessing realignment risk (i.e., assessing the credibility of the target zone) during the
period of turbulence. In terms of quantitative estimation, the FPT approach gives much
clearer signals of realignment risk than those given by the path-independent approach.
It is noted that under the FPT approach the probabilities estimated with the mean-
reverting process is lower than those estimated with the lognormal process. It is because the
mean-reverting process will push the exchange rate back towards the central parity and thus
reduces the realignment risk, when the exchange rate is between the central parity and the
lower band limit during the period from 31 March to 16 September 1992. This means that
the higher the speed of reversion, the lower the probabilities will be under the mean-reverting
process.
7
However, the surges of the first-hitting probabilities estimated under the mean-
reverting process after the second half of August are similar to those under the lognormal
process. The results show that the realignment risk during the period before the pound left

7
A strong mean reversion could come about due to interventions in the foreign exchange market by the central
banks. Such interventions have been shown in many studies (see MacDonald (1988)). An underlying feature of
the interventions is apparently that the authorities try to bring the exchange rate back to some normal level or
central parity. A natural way to model this is through a mean-reverting process for the exchange rate.
12
the ERM is mainly attributed to the existence of the boundary which captures any
realignment within the one-month time horizon.
Based on the FPT density, the first-hitting time
0
and the time
1
of the
corresponding maximum slope of the FPT density from 2 January 1992 to 16 September
1992 are presented in Figure 2 and are compared with the one-month first-hitting
probabilities over the same period. The model parameters are the same as those used in
Figure 1.
Figure 2 shows that
0
and
1
estimated by the FPT approach move in opposite
directions compared with the movements of the first-hitting probability because the longer
0

and
1
mean a lower probability of the exchange rate hitting a band limit. However, their
movements do not change at the same time and there are time lags between them. The first-
hitting probability increases from the level of 0.02 as at 8 July to the level of 0.05 as at the
end of July. Regarding
0
and
1
, their values drop sharply before the end of June. The first-
hitting time
0
decreases from about 1 year at 26 June to 0.16 year (about 2 months) at 8 July.
Similarly, the time
1
of the corresponding maximum slope of the FPT density decreases from
0.31 year to 0.06 year over the same period. The changes in
0
and
1
indicate that the FPT
density contains forward-looking information about the likelihood of the pound hitting a band
limit.
The first-hitting probability which is obtained by integrating the FPT density from
time zero to a certain time period (say one month) may not capture the critical characteristics
of the FPT density in order to identity any changes in the likelihood of the exchange rate
hitting a band limit. On the other hand, the first-hitting time identifies the maximum of the
FPT density, and the time of the maximum slope of the FPT density identifies when the
exchange rate will move towards a band limit at the maximum capacity. As these two
13
measures identify the critical quantities (i.e., the maximum measures) of the FPT density,
they are more sensitive to the changes in the information contained in the density and thus
reflect the assessment of the realignment risk (credibility) of the target zone more timely than
the first-hitting probability. Having said that, the first-hitting probabilities rise sharply in the
second half of August while the values of
0
and
1
are very small. This shows that the first-
hitting probability is a useful complementary measure for monitoring and assessing the
realignment risk during a period of turbulence.
Figure 3 shows
0
and
1
under the mean-reverting process and the lognormal
process. The values of
0
and
1
estimated with the mean-reverting process are higher than
those estimated with the lognormal process. However, when the time measures are low (i.e.,
the likelihood of the exchange rate hitting a band is high), the differences are very small. The
results are consistent with those in Figure 1 as the mean-reverting process will push the
exchange rate back towards the central parity and thus increase the first-hitting time and the
time of the maximum slope of the FPT density, when the exchange rate is between the central
parity and the lower band limit during the period. This means that the higher the speed of
reversion, the longer the time measures of
0
and
1
will be under the mean-reverting
process.
For assessing the realignment risk by the three measures in a narrower target zone
than that of the pound, market data of the lira from 2 January 1992 to 11 September 1992 are
used for the estimation. The lira was in the narrow % 25 . 2 EMS band with the central
parity at ITL748.217 per DEM, which is narrower than that of the pound. On 13 September
1992, the lira left the ERM with a devaluation of about 15% afterward. The input model
parameters are market data of S, r, r* and the exchange rate volatility which is estimated
from daily exchange rate data by the exponentially weighted moving average (EWMA)
14
method.
8
For the mean-reverting process, the conditional mean exchange rate is set at
central parity and the speed of reversion is set to be 17.86.
9

Figure 4 shows that in a one-month horizon the first-hitting probabilities under the
FPT approach with the lognormal process are consistently higher than the realignment
probabilities obtained by the path-independent approach with the lognormal process. Before
the lira left the ERM, the probabilities estimated by the FPT approach, which have been
above 0.7 since 20 August 1992, are substantially higher than those (about 0.5) estimated by
the path-independent approach. In particular, the probabilities estimated by the FPT
approach are higher than 0.8 in September, while the corresponding probabilities estimated
by the path-independent approach range only between 0.5 and 0.6. Similar to the results in
Figure 1, the realignment risk during the period before the lira left the ERM is mainly
attributed to the existence of the boundary which captures any realignment within the one-
month horizon. Because of the strong mean reversion of the lira in the narrow EMS band, the
first-hitting probabilities estimated by the FTP approach with the mean-reverting process are
much lower more than those with the lognormal process, compared with Figure 1 where the
mean reversion of the pound is relatively weak. Sometimes, they are even lower than the
realignment probabilities estimated by the time-independent approach with the lognormal
process.

8
We do not have option implied volatility for the lira, i.e., the jump-diffusion process cannot be estimated. The
daily volatility of the lira based on the EWMA method is given by
2
1
2 2
) 1 (

+ =
t t t
R , where R
t
is the daily
return of the ITL/DEM exchange rate and is the decay factor which is set to be 0.94. The initial
2
t
is
estimated from the average of the first 74 observations of the data series starting from 2 January 1990 according
to J.P. Morgan & Co. (1995).
2
t
is used for both the FPT approach and the path-independent approach such
that their results are comparable. Other market data are from Bloomberg.
9
is estimated by applying the maximum likelihood technique to the mean-reverting specification of S using
704 daily observations of the ITL/DEM exchange rate in the period from 2 January 1990 to 11 September 1992
when the lira was in the EMS band. The corresponding estimated is ITL747.616 per DEM. It is not the
objective of this paper to investigate the mean-reverting behaviour of the exchange rates in the ERM. The
estimation is just for the purpose of numerical illustrations of the mean-reverting model.
15
Figure 5 shows that in a one-month horizon the first-hitting probabilities under the
lognormal process are in general high and the corresponding values of the first-hitting time
0
and the time
1
of the corresponding maximum slope of the FPT density of the lira are low.
Their movements are more volatile compared with the corresponding measures of the pound
over the same period. The results are attributed to the narrow % 25 . 2 band that increases
the likelihood of the lira hitting a band limit. While the surge in the first-hitting probability in
June signals an increase in the realignment risk of the lira, the measures
0
and
1
drop
almost at the same time. After the drop,
0
and
1
stayed at the level of below 0.05 year (i.e.,
less than a month) and 0.02 year respectively until 11 September. The small values of
0

mean that the lira could escape from the lower band limit within a month. During the period
between mid-July and mid-September, the first-hitting probability ranges between 0.4 and 0.9.
Compared to the first-hitting probability, the two time measures persistently give signals of
high realignment risk of the lira target zone.
Compared with Figure 5, the movements of the measures under the mean-reverting
process over time in Figure 6 are more volatile because of the more complex dynamics of the
exchange rate due to a strong mean reversion in the narrow EMS band. Nevertheless, the
first-hitting time
0
drops in mid-August before the first-hitting probability surges in early
September. This reflects that under the mean-reverting process, the first-hitting time provides
early signals for assessing realignment risk. Similar to the results in Figure 5, during the
period between mid-July and mid-September, the first-hitting probability ranges between
0.13 and 0.85, while the small values of the two time measures
0
and
1
persistently give
signals of high realignment risk of the lira target zone. The values of the first-hitting time
during this period of time indicate that the lira could escape from the lower band limit within
a month.
16
4. Conclusion
This paper proposes a path-dependent approach based on the FPT density for
estimating realignment probabilities of currencies in target zones and considers that path
dependency is an intrinsic characteristic of realignment risk. The path-independent approach
adapted by Malz (1996) ignores the possibility of realignment prior to the end of a specified
time horizon. In essence, this perspective assumes that the realignment risk remains zero
regardless of the changes in the exchange rate during a time horizon. However, if the
exchange rate breaches a pre-specified band limit (i.e., a boundary), realignment can occur.
Based on the ERM crisis in 1992, the realignment probabilities of the pound and lira
estimated under the FPT approach show that boundaries are quantitatively significant,
compared with the path-independent approach. A central bank which adopts a targeted or
managed-floating exchange rate regime could interpret implied first-hitting probabilities
based on the FPT approach as an indicator to assess the realignment risk.
The two other proposed measures of realignment risk, the first-hitting time and the
time of the maximum slope of the FPT density, are found to have forward-looking capability
for assessing realignment risk of the pound and lira target zones. These two measures signal
the changes in the realignment risk in the pound target zone when the first-hitting probability
is close to zero and the target zone is believed to be fully credible. Their values had been
persistently low before the lira left the ERM that demonstrates their capability for assessing
realignment risk of the lira.

Acknowledgements
The authors gratefully acknowledge useful comments from Hans Genberg and assistance
from Chi-sang Tam and Laurence Fung. The conclusions herein do not represent the views
of the Hong Kong Monetary Authority.
17
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19
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
31/03/92 16/04/92 02/05/92 18/05/92 03/06/92 19/06/92 05/07/92 21/07/92 06/08/92 22/08/92 07/09/92
Date
P
r
o
b
a
b
i
l
i
t
y
Path-independent approach (jump diffusion)
Malz (1996)
FPT approach (lognormal)
FPT approach (mean reversion)
Path-independent approach
(lognormal)

Figure 1. First-hitting probability based on FPT approach and realignment probability based
on path-independent approach of GBP in next month from 31 March 1992 to 16 September
1992.
20
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
02/01/92 06/02/92 12/03/92 16/04/92 27/05/92 01/07/92 05/08/92 10/09/92
Date
P
r
o
b
a
b
i
l
i
t
y
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
T
i
m
e

(
y
e
a
r
)
First-hitting probability
(LHS)
Time of maximum slope of FPT density
1
(RHS)
First-hitting time
0
(RHS)

Figure 2. First-hitting probability in next month, first-hitting time and time of maximum
slope of FPT density of GBP under mean-reverting process from 2 January 1992 to 16
September 1992.
21
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
02/01/92 06/02/92 12/03/92 16/04/92 27/05/92 01/07/92 05/08/92 10/09/92
Date
T
i
m
e

(
y
e
a
r
)
Time of maximum slope of FPT density
1
(mean reversion)
Time of maximum slope of FPT density
1
(lognormal)
First-hitting time
0
(lognormal)
First-hitting time
0
(mean reversion)

Figure 3. First-hitting time and time of maximum slope of FPT density of GBP under mean-
reverting process and lognormal process from 2 January 1992 to 16 September 1992.
22
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
02/01/1992 06/02/1992 12/03/1992 16/04/1992 21/05/1992 25/06/1992 30/07/1992 03/09/1992
Date
P
r
o
b
a
b
i
l
i
t
y
FPT approach
(mean reversion)
FPT approach
(lognormal)
Path-independent
approach
(lognormal)

Figure 4. First-hitting probability based on FPT approach and realignment probability based
on path-independent approach of ITL in next month from 2 January 1992 to 11 September
1992.
23
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
02/01/1992 06/02/1992 12/03/1992 16/04/1992 21/05/1992 25/06/1992 30/07/1992 03/09/1992
Date
P
r
o
b
a
b
i
l
i
t
y
0.00
0.05
0.10
0.15
0.20
0.25
T
i
m
e

(
y
e
a
r
)
Time of maximum
slope of FPT
density
1
(RHS)
First-hitting probability
(LHS)
First-hitting time
0
(RHS)

Figure 5. First-hitting probability in next month, first-hitting time and time of maximum
slope of FPT density of ITL under lognormal process from 2 January 1992 to 11 September
1992.
24
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
02/01/1992 06/02/1992 12/03/1992 16/04/1992 21/05/1992 25/06/1992 30/07/1992 03/09/1992
Date
P
r
o
b
a
b
i
l
i
t
y
0.00
0.05
0.10
0.15
0.20
0.25
T
i
m
e

(
y
e
a
r
)
Time of maximum
slope of FPT
density
1
(RHS)
First-hitting probability
(LHS)
First-hitting time
0
(RHS)

Figure 6. First-hitting probability in next month, first-hitting time and time of maximum
slope of FPT density of ITL under mean-reverting process from 2 January 1992 to 11
September 1992.