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Extracting Information from Asset Prices: the Methodology of EMU Calculators

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  • Carlo A. Favero
  • Francesco Giavazzi
  • Fabrizio Iacone
  • Guido Tabellini

Abstract

This paper analyses how to extract market expectations from asset prices, with a particular example: using the term structure of interest rates to estimate the probability the market attaches to the event that a country, Italy, joins the European Monetary Union at a given date. The extraction of such a probability from the term structure is based on the presumption that the term structure contains valuable information regarding the markets' assessment of a country's chances to join the EMU. The case of Italy is interesting because in the survey regularly conducted by Reuters the probability of joining EMU in 1999 fluctuated between 0.07 and 0.15, while, during the same period, the measures of computed by financial houses -- also based on the term structure of interest rates -- have 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 ine fficiencies, but depend on an 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.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 113.

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Handle: RePEc:igi:igierp:113

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  1. Clarida, R. & Gertler, M., 1996. "How the Bundesbank Conducts Monetary Policy," Working Papers 96-14, C.V. Starr Center for Applied Economics, New York University.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1996. "Sticky Price and Limited Participation Models of Money: A Comparison," NBER Working Papers 5804, National Bureau of Economic Research, Inc.
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  12. Angeloni, I. & Violi, R., 1997. "Long-Term Interest Rate Convergence in Europe and the Probability of EMU," Papers 322, Banca Italia - Servizio di Studi.
  13. Flood, Robert P & Garber, Peter M, 1983. "A Model of Stochastic Process Switching," Econometrica, Econometric Society, vol. 51(3), pages 537-51, May.
  14. Gerlach, Stefan & Smets, Frank, 1995. "The Term Structure of Euro-Rates: Some Evidence in Support of the Expectations Hypothesis," CEPR Discussion Papers 1258, C.E.P.R. Discussion Papers.
  15. De Grauwe, Paul, 1996. "Forward Interest Rates as Predictors of EMU," CEPR Discussion Papers 1395, C.E.P.R. Discussion Papers.
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Citations

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Cited by:
  1. 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.
  2. Juan-Angel Jimenez-Martin & Alfonso Novales Cinca, 2009. "State-Uncertainty preferences and the Risk Premium in the Exchange rate market," Documentos del Instituto Complutense de Análisis Económico 0908, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. Naszódi, Anna, 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.
  9. 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.
  10. Gabriel Fagan & Vitor Gaspar, 2008. "Macroeconomic Adjustment to Monetary Union," Working Papers 2008/14, Czech National Bank, Research Department.
  11. 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.
  12. 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.
  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. Gabriel Fagan & Vítor Gaspar, 2007. "Adjusting to the Euro," Working Papers w200703, Banco de Portugal, Economics and Research Department.

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