A Note on Estimating Realignment Probabilities -- A First-Passage-Time Approach
AbstractThis paper proposes a path-dependent approach for estimating realignment probabilities of targeted exchange rates based on first-passage-time distributions instead of the commonly used path-independent approach. We consider that path dependency is an intrinsic characteristic of realignment risk because a realignment of an exchange rate can occur whenever a committed band by a central bank is breached. A mean-reverting lognormal process is considered in the first-passage-time approach. Based on market data of the British pound and mark during the ERM crisis of 1992, the realignment probabilities of the pound estimated under the proposed approach show that path dependency is quantitatively significant, compared with the path-independent approach.
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Bibliographic InfoPaper provided by Hong Kong Monetary Authority in its series Working Papers with number 0809.
Length: 15 pages
Date of creation: Jun 2008
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realignment risk; mean-reversion; first-passage-time probability;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-07-30 (All new papers)
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