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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
  • Tabellini, Guido

Abstract

This paper develops a particular technique for extracting market expectations from asset prices. We use the term structure of interest rates to estimate the probability the market attaches to a country, Italy, joining the European Monetary Union at a given date. The extraction of such a probability is based on the presumption that the term structure contains valuable information regarding the markets’ assessment of a country’s chances of joining EMU. The case of Italy is interesting because in the survey regularly conducted by Reuters the probability that Italy joins EMU in 1999 fluctuated, in the first months of 1997, between 0.07 and 0.15 while during the same period the measures computed by financial houses – which are based on the term structure of interest rates – 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 inefficiencies, but of 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. It could also be applied, more generally, to extract information on imminent changes in an exchange rate regime from asset prices.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1676.

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Date of creation: Jul 1997
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Handle: RePEc:cpr:ceprdp:1676

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Keywords: Expectational Model; Probabilities of entering EMU; Term Structure of Interest Rates;

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References

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  1. King, Mervyn, 1995. "Credibility and Monetary Policy: Theory and Evidence," Scottish Journal of Political Economy, Scottish Economic Society, vol. 42(1), pages 1-19, February.
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Citations

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Cited by:
  1. Fagan, Gabriel & Gaspar, Vítor, 2007. "Adjusting to the euro," Working Paper Series 0716, European Central Bank.
  2. Viktors Ajevskis & Kristine Vitola, 2010. "A Convergence Model of the Term Structure of Interest Rates," Review of Finance, European Finance Association, vol. 14(4), pages 727-747.
  3. Juan-Ángel Jiménez-Martín & Alfonso Novales Cinca, 2009. "State-Uncertainty preferences and the Risk Premium in the Exchange rate market," Documentos de Trabajo del ICAE 0917, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
  4. 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.
  5. Anna Naszódi, 2007. "Are the Exchange Rates of EMU Candidate Countries Anchored by their Expected Euro Locking Rates?," Focus on European Economic Integration, Oesterreichische Nationalbank (Austrian Central Bank), issue 1, pages 115-134.
  6. 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.
  7. 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.
  8. Reher, Gerrit & Wilfling, Bernd, 2014. "The valuation of European call options on zero-coupon bonds in the run-up to a fixed exchange-rate regime," International Review of Economics & Finance, Elsevier, vol. 29(C), pages 483-496.
  9. 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.
  10. 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.
  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. Juan-Ángel Jiménez-Martín & Rodrigo Peruga Urrea, 2004. "Macroeconomic and policy uncertainty and Exchange rate risk Premium," Documentos de Trabajo del ICAE 0412, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
  13. 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.
  14. Fagan, Gabriel & Gaspar, Vítor, 2008. "Macroeconomic adjustment to monetary union," Working Paper Series 0946, European Central Bank.
  15. Marchetti, Domenico J. & Nucci, Francesco, 2005. "Price stickiness and the contractionary effect of technology shocks," European Economic Review, Elsevier, vol. 49(5), pages 1137-1163, July.
  16. 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.

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