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Deriving Market Expectations for the Euro-Dollar Exchange Rate From Option Prices

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  • Noureddine Krichene
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    Abstract

    Option prices provide valuable information on market expectations. This paper attempts to extract market expectations, as conveyed by an implied risk-neutral probability distribution, from option prices for the dollar-euro exchange rate. Returns'' volatilities are inferred from observed and interpolated option prices. To address robustness, two distributions, one from actual data and the other from interpolated data, were computed. The main conclusion of the paper is that traders have wide-ranging expectations, and large movements in either direction would not occur as a surprise. The main implication for monetary policy is that should markets become too volatile, then intervention may be required.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 04/196.

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    Length: 24
    Date of creation: 01 Oct 2004
    Date of revision:
    Handle: RePEc:imf:imfwpa:04/196

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    Related research

    Keywords: Exchange rates; Emerging markets; Euro; Economic models; equation; probability; skewness; probability distribution; probabilities; derivative; equations; hedging; kurtosis; probability density; stochastic process; lognormal distribution; calibration; linear system; normal distribution; bond; characteristic function; probability density function; hedging strategies; martingale; computation; financial economics; conditional expectation; financial markets; diffusion process; extrapolation; markov process; difference equation; bonds; partial derivatives; option valuation; cumulative distribution function; discount bond; stochastic differential equation; hedge; risk-free interest rate; derivative securities; diffusion processes; international financial markets; stock options; stochastic processes; characteristic functions; hedging instruments; diffusion model; functional form; mathematics; time series; diagonal matrix; financial stability; derivatives ? markets; stochastic discount; probability functions; valuation of options; least squares method; finite element methods; derivative security; financial policies; financial derivatives;

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    References

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    1. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-43.
    2. Bakshi, Gurdip & Madan, Dilip, 2000. "Spanning and derivative-security valuation," Journal of Financial Economics, Elsevier, vol. 55(2), pages 205-238, February.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    4. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
    5. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
    6. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
    7. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
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    Cited by:
    1. Bednarik, Radek, 2008. "Analýza volatility devizových kurzů vybraných ekonomik
      [The Analysis of Volatility of Selected Countries' Exchange Rates]
      ," MPRA Paper 15046, University Library of Munich, Germany.
    2. Fabrice Rousseau & Laurent Germain & Fabrice Rousseau & Anne Vanhems, 2008. "Irrational Financial Markets," Economics, Finance and Accounting Department Working Paper Series n1870108.pdf, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.

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