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Option-implied probability distributions and currency excess returns

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  • Allan M. Malz
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    Abstract

    This paper describes a method of extracting the risk-neutral probability distribution of future exchange rates from option prices. In foreign exchange markets interbank option pricing conventions make possible reliable inferences about risk-neutral probability distributions with relatively little data. Moments drawn from risk-neutral exchange rate distribution are used to explore several issues related to the puzzle of excess returns in currency markets. Tests of the international capital asset pricing model using risk-neutral moments as explanatory variables indicate that option-based moments have considerably greater explanatory power for excess returns in currency markets than has been found in earlier work. Tests of several hypotheses generated by the peso problem approach indicate that jump risk measured by the risk-neutral coefficient of skewness can explain only a small part of the forward bias. These tests take into account not only the second, but the third and fourth moments of the exchange rate implied by option prices, and avoid testing a joint hypothesis including a distributional assumption.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 32.

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    Date of creation: 1997
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    Handle: RePEc:fip:fednsr:32

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    Related research

    Keywords: Options (Finance) ; Foreign exchange rates ; Capital assets pricing model;

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    Cited by:
    1. Martin Cincibuch & David Vavra, 2004. "Testing for the uncovered interest parity using distributions implied by FX options," Money Macro and Finance (MMF) Research Group Conference 2003 16, Money Macro and Finance Research Group.
    2. Bliss, Robert R. & Panigirtzoglou, Nikolaos, 2002. "Testing the stability of implied probability density functions," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 381-422, March.
    3. L. Spadafora & G. P. Berman & F. Borgonovi, 2011. "Adiabaticity conditions for volatility smile in Black-Scholes pricing model," The European Physical Journal B - Condensed Matter and Complex Systems, Springer, vol. 79(1), pages 47-53, January.
    4. Marie Brière & Kamal Chancari, 2004. "Perception des risques sur les marchés, construction d'un indice élaboré à partir des smiles d'options et test de stratégies," Revue d'économie politique, Dalloz, vol. 0(4), pages 527-555.
    5. Robert R Bliss & Nikolaos Panigirtzoglou, 2000. "Testing the stability of implied probability density functions," Bank of England working papers 114, Bank of England.
    6. Taylor, Stephen J. & Yadav, Pradeep K. & Zhang, Yuanyuan, 2010. "The information content of implied volatilities and model-free volatility expectations: Evidence from options written on individual stocks," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 871-881, April.
    7. Gnabo, Jean-Yves & Teiletche, Jérôme, 2009. "Foreign-exchange intervention strategies and market expectations: insights from Japan," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(3), pages 432-446, July.
    8. Aron Gereben, 2002. "Extracting market expectations from option prices: an application to over-the-counter New Zealand dollar options," Reserve Bank of New Zealand Discussion Paper Series DP2002/04, Reserve Bank of New Zealand.
    9. Aron Gereben, 2002. "Extracting market expectations from option prices?," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 65, March.
    10. Marie Briere, 2006. "Market Reactions to Central Bank Communication Policies :Reading Interest Rate Options Smiles," Working Papers CEB 38, ULB -- Universite Libre de Bruxelles.
    11. Ruijun Bu & Kaddour Hadri, 2005. "Estimating the Risk Neutral Probability Density Functions Natural Spline versus Hypergeometric Approach Using European Style Options," Research Papers 200510, University of Liverpool Management School.

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