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.
Length: Date of creation: Date of revision: Handle: RePEc:igi:igierp:113
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Richard H. Clarida & Mark Gertler, 1997.
"How the Bundesbank Conducts Monetary Policy,"
NBER Chapters,
in: Reducing Inflation: Motivation and Strategy, pages 363-412
National Bureau of Economic Research, Inc.
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Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)
Arturo Bris & Yrjö Koskinen & Mattias Nilsson, 2009.
"The Euro and Corporate Valuations,"
Review of Financial Studies,
Oxford University Press for Society for Financial Studies, vol. 22(8), pages 3171-3209, August.
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