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Implied Exchange Rate Distributions: Evidence from OTC Option Markets

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  • Jose M. Campa
  • P.H. Kevin Chang
  • Robert L. Reider

Abstract

This paper uses a rich new data set of option prices on the dollar-mark, dollar-yen, and key EMS cross-rates to extract the entire risk-neutral probability density function (pdf) over horizons of one and three months. We compare three alternative smoothing methods---cubic splines, an implied binomial tree (trimmed and untrimmed), and a mixture of lognormals---for transforming option data into the pdf. Despite their methodological ifferences, the three approaches lead to a similar pdf distinct from the lognormal benchmark, and usually characterized by skewness and leptokurtosis. We then document a striking positive correlation between skewness in these pdfs and the spot rate. The stronger a currency the more expectations are skewed towards a further appreciation of that currency. We interpret this finding as a rejection that these exchange rates evolve as a martingale, or that they follow a credible target zone, explicit or implicit. Instead, this this positive correlation is consistent with target zones with endogenous realignment risk. We discuss two interpretations of our results on skewness: when a currency is stronger, the actual probability of further large appreciation is higher, or because of risk, such states are valued more highly.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6179.

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Date of creation: Sep 1997
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Publication status: published as Journal of International Money and Finance, Vol. 17, no. 1 (February 1998): 117-160.
Handle: RePEc:nbr:nberwo:6179

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  15. Malz, Allan M., 1996. "Using option prices to estimate realignment probabilities in the European Monetary System: the case of sterling-mark," Journal of International Money and Finance, Elsevier, Elsevier, vol. 15(5), pages 717-748, October.
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Citations

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Cited by:
  1. Li, Minqiang, 2008. "Price Deviations of S&P 500 Index Options from the Black-Scholes Formula Follow a Simple Pattern," MPRA Paper 11530, University Library of Munich, Germany.
  2. Carr, Peter & Wu, Liuren, 2007. "Stochastic skew in currency options," Journal of Financial Economics, Elsevier, Elsevier, vol. 86(1), pages 213-247, October.
  3. Gustavo Abarca & Claudia Ramírez & José Gonzalo Rangel, 2012. "Capital Controls and Exchange Rate Expectations in Emerging Markets," Working Papers, Banco de México 2012-08, Banco de México.
  4. Steven A. Weinberg, 2001. "Interpreting the volatility smile: an examination of the information content of option prices," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 706, Board of Governors of the Federal Reserve System (U.S.).
  5. Mc Manus, Des, 1999. "The Information Content of Interest Rate Futures Options," Working Papers, Bank of Canada 99-15, Bank of Canada.
  6. Ribeiro de Castro, Claudia, 1999. "Inside and Outside the Band Exchange Rate Fluctuations for Brazil," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales), Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES) 2000004, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
  7. David Backus & Silverio Foresi & Liuren Wu, 2002. "Accouting for Biases in Black-Scholes," Finance, EconWPA 0207008, EconWPA.
  8. Vahamaa, Sami, 2005. "Option-implied asymmetries in bond market expectations around monetary policy actions of the ECB," Journal of Economics and Business, Elsevier, Elsevier, vol. 57(1), pages 23-38.
  9. Aron Gereben, 2002. "Extracting market expectations from option prices: an application to over-the-counter New Zealand dollar options," Reserve Bank of New Zealand Discussion Paper Series DP2002/04, Reserve Bank of New Zealand.
  10. Robert R Bliss & Nikolaos Panigirtzoglou, 2000. "Testing the stability of implied probability density functions," Bank of England working papers 114, Bank of England.
  11. Bliss, Robert R. & Panigirtzoglou, Nikolaos, 2002. "Testing the stability of implied probability density functions," Journal of Banking & Finance, Elsevier, Elsevier, vol. 26(2-3), pages 381-422, March.
  12. Martin Cincibuch, 2002. "Distributions Implied by Exchange Traded Options: A Ghost’s Smile?," CERGE-EI Working Papers wp200, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  13. Michael W. Brandt & Pedro Santa-Clara, 2001. "Simulated Likelihood Estimation of Diffusions with an Application to Exchange Rate Dynamics in Incomplete Markets," NBER Technical Working Papers 0274, National Bureau of Economic Research, Inc.
  14. Bødskov Andersen, Allan & Wagener, Tom, 2002. "Extracting risk neutral probability densities by fitting implied volatility smiles: some methodological points and an application to the 3M Euribor futures option prices," Working Paper Series, European Central Bank 0198, European Central Bank.
  15. Bronka Rzepkowski, 2001. "Heterogeneous Expectations, Currency Options and the Euro / Dollar Exchange Rate," Working Papers 2001-03, CEPII research center.
  16. Marie Briere, 2006. "Market Reactions to Central Bank Communication Policies :Reading Interest Rate Options Smiles," Working Papers CEB, ULB -- Universite Libre de Bruxelles 38, ULB -- Universite Libre de Bruxelles.

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