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Using option prices to estimate realignment probabilities in the European Monetary System

Author

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  • Allan M. Malz

Abstract

Risk reversals are a combination of options from which price information about market expectations of future exchange rates can be extracted. This paper describes a procedure for estimating the market's perceived probability distribution of future exchange rates from the prices of risk reversals and other currency options. This procedure is used to estimate the ex ante probability of a realignment of the French franc and pound sterling. The procedure for estimating the realignment probabilities relies on the jump-diffusion model of exchange rate behavior and the resulting option pricing formula. By fitting this model to market option price data, the unobserved parameters of the jump-diffusion process are retrieved. These parameter estimates form the basis for estimating the ex ante probability distribution of exchange rates and thus the realignment probabilities.

Suggested Citation

  • Allan M. Malz, 1995. "Using option prices to estimate realignment probabilities in the European Monetary System," Staff Reports 5, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:5
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    Citations

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    Cited by:

    1. Michael P. Leahy & Charles P. Thomas, 1996. "The sovereignty option: the Quebec referendum and market views on the Canadian dollar," International Finance Discussion Papers 555, Board of Governors of the Federal Reserve System (U.S.).
    2. Roy Stein & Yoel Hecht, 2003. "Distribution of the Exchange Rate Implicit in Option Prices: Application to TASE," Bank of Israel Working Papers 2003.05b, Bank of Israel.
    3. Bhupinder Bahra, 1997. "Implied risk-neutral probability density functions from option prices: theory and application," Bank of England working papers 66, Bank of England.

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