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Extracting information from asset prices: The methodology of EMU calculators

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  • Favero, Carlo A.
  • Giavazzi, Francesco
  • Iacone, Fabrizio
  • Guido Tabellini

Abstract

This paper analyses how to extract market expectations from asset prices, with a particular example: using the term structure of interest rates to estimate the probability the market attaches to the event that a country, Italy, joins the European Monetary Union at a given date. The extraction of such a probability from the term structure is based on the presumption that the term structure contains valuable information regarding the markets' assessment of a country's chances to join the EMU. The case of Italy is interesting because in the survey regularly conducted by Reuters the probability of joining EMU in 1999 fluctuated between 0.07 and 0.15, while, during the same period, the measures of computed by financial houses -- also based on the term structure of interest rates -- have ranged between 0.5 and 0.8. The paper proposes a new method for computing these probabilities, and shows that the discrepancies between survey and market-based measures are not the result of market ine fficiencies, but depend on an incorrect use of the term structure to compute probabilities. The technique proposed in the paper can also be used to distinguish between convergence of probabilities and convergence of fundamentals, that is to find out whether an observed reduction in interest rate spreads signals a higher probability of joining EMU at a given time, or simply reflects improved fundamentals.

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Bibliographic Info

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 44 (2000)
Issue (Month): 9 (October)
Pages: 1607-1632

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Handle: RePEc:eee:eecrev:v:44:y:2000:i:9:p:1607-1632

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  1. Soderlind, Paul & Svensson, Lars, 1997. "New techniques to extract market expectations from financial instruments," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 383-429, October.
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Citations

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Cited by:
  1. Gabriel Fagan & Vítor Gaspar, 2007. "Adjusting to the euro," Working Paper Series 716, European Central Bank.
  2. Juan-Ángel Jiménez-Martín & Alfonso Novales Cinca, 2009. "State-Uncertainty preferences and the Risk Premium in the Exchange rate market," Documentos del Instituto Complutense de Análisis Económico 0917, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales.
  3. Livio Stracca, . "Economics and Politics: Interest Rate Convergence in Europe and EMU," Discussion Papers in European Economics 99/6, Department of Economics, University of Leicester.
  4. Viktors Ajevskis & Kristine Vitola, 2009. "A Convergence Model of the Term Structure of Interest Rates," Working Papers 2009/01, Latvijas Banka.
  5. Gabriel Fagan & Vitor Gaspar, 2008. "Macroeconomic Adjustment to Monetary Union," Working Papers 2008/14, Czech National Bank, Research Department.
  6. Anna Naszódi, 2008. "Are the exchange rates of EMU candidate countries anchored by their expected euro locking rates?," MNB Working Papers 2008/1, Magyar Nemzeti Bank (the central bank of Hungary).
  7. Wilfling, Bernd, 2009. "Volatility regime-switching in European exchange rates prior to monetary unification," Journal of International Money and Finance, Elsevier, vol. 28(2), pages 240-270, March.
  8. Juan Ángel Jiménez Martín & Rodrigo Peruga Urrea, 2003. "La Transición al Euro y la Prima de Riesgo en el Mercado de Divisas," Documentos del Instituto Complutense de Análisis Económico 0306, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales.
  9. Arturo Bris & Yrjö Koskinen & Mattias Nilsson, 2009. "The Euro and Corporate Valuations," Review of Financial Studies, Society for Financial Studies, vol. 22(8), pages 3171-3209, August.
  10. Martin Cincibuch & Matrina Horníková, 2008. "Measuring the Financial Markets’ Perception of EMU Enlargement: The Role of Ambiguity Aversion," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 58(05-06), pages 210-230, August.
  11. Driessen, Joost & Perotti, Enrico, 2011. "Confidence building on Euro convergence: Evidence from currency options," Journal of International Money and Finance, Elsevier, vol. 30(3), pages 474-491, April.
  12. Jean-Paul Pollin & Servane Pfister & Raphaelle Bellando, 2000. "Évolution et déterminants de la crédibilité de l’Union Monétaire Européenne durant la phase de transition : une étude comparative France, Italie et Grande-Bretagne," Revue d'Économie Financière, Programme National Persée, vol. 56(1), pages 165-194.
  13. Hallerberg, Mark, 2000. "The importance of domestic political institutions: Why and how Belgium and Italy qualified for EMU," ZEI Working Papers B 10-2000, ZEI - Center for European Integration Studies, University of Bonn.
  14. Driessen, Joost & Perotti, Enrico C, 2004. "Confidence Building on Euro Conversion: Theory and Evidence from Currency Options," CEPR Discussion Papers 4180, C.E.P.R. Discussion Papers.

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