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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. Soderlind, P & Svensson, L-E-O, 1996. "New Techniques to Extract Market Expectations from Financial Instruments," Papers 621, Stockholm - International Economic Studies.
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Citations

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Cited by:
  1. 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.
  2. Martin Cincibuch & Martina Hornikova, 2007. "Measuring the Financial Markets' Perception of EMU Enlargement: The Role of Ambiguity Aversion," Working Papers 2007/13, Czech National Bank, Research Department.
  3. Gabriel Fagan & Vítor Gaspar, 2007. "Adjusting to the Euro," Working Papers w200703, Banco de Portugal, Economics and Research Department.
  4. 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.
  5. 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.
  6. Bris, Arturo & Koskinen, Yrjö & Nilsson, Mattias, 2003. "The Euro and Corporate Valuations," Working Paper Series in Economics and Finance 525, Stockholm School of Economics, revised 06 Dec 2003.
  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. Jiménez-Martín, Juan-Ángel & Cinca, Alfonso Novales, 2010. "State-uncertainty preferences and the risk premium in the exchange rate market," Economic Modelling, Elsevier, vol. 27(5), pages 1043-1053, September.
  9. 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.
  10. 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.
  11. Gabriel Fagan & Vitor Gaspar, 2008. "Macroeconomic Adjustment to Monetary Union," Working Papers 2008/14, Czech National Bank, Research Department.
  12. 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.
  13. 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).
  14. Juan-Ángel Jiménez-Martín & Rodrigo Peruga Urrea, 2004. "Macroeconomic and policy uncertainty and Exchange rate risk Premium," Documentos del Instituto Complutense de Análisis Económico 0412, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales.
  15. 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.
  16. 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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