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Extracting market expectations from option prices: an application to over-the-counter New Zealand dollar options

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Abstract

What are the odds of a large shift in the exchange rate? Is a large depreciation more likely than a large appreciation? This paper uses over-the-counter New Zealand dollar/US dollar option prices to quantify market expectations of exchange rate uncertainty through measures based on risk-neutral probability distribution functions. Results suggest that the estimated probability distributions can provide important insights into market perceptions about exchange rate risk in the future. Econometric evidence indicates that the higher moments calculated from risk-neutral probability density functions can be used to explain the dynamic behaviour of the forward bias measured in the New Zealand dollar/US dollar exchange rate.

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Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP2002/04.

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Length: 23p
Date of creation: Apr 2002
Date of revision:
Handle: RePEc:nzb:nzbdps:2002/04

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  1. Robert R Bliss & Nikolaos Panigirtzoglou, 2000. "Testing the stability of implied probability density functions," Bank of England working papers, Bank of England 114, Bank of England.
  2. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  3. Melick, William R. & Thomas, Charles P., 1997. "Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 32(01), pages 91-115, March.
  4. Allan M. Malz, 1997. "Option-implied probability distributions and currency excess returns," Staff Reports, Federal Reserve Bank of New York 32, Federal Reserve Bank of New York.
  5. Jose M. Campa & P.H. Kevin Chang & Robert L. Reider, 1997. "Implied Exchange Rate Distributions: Evidence from OTC Option Markets," NBER Working Papers 6179, National Bureau of Economic Research, Inc.
  6. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
  7. Yuong Ha & Michael Reddell, 1998. "What do forward interest and exchange rates tell us?," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, Reserve Bank of New Zealand, vol. 61, June.
  8. Richard K. Lyons, 1986. "Tests of the foreign exchange risk premium using the expected second moments implied by option pricing," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 290, Board of Governors of the Federal Reserve System (U.S.).
  9. Bhupinder Bahra, 1997. "Implied risk-neutral probability density functions from option prices: theory and application," Bank of England working papers, Bank of England 66, Bank of England.
  10. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, American Finance Association, vol. 49(3), pages 771-818, July.
  11. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(1-2), pages 145-166.
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  13. Newey, Whitney K & West, Kenneth D, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 61(4), pages 631-53, October.
  14. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 51(4), pages 621-51, October.
  15. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers, University of California at Berkeley RPF-232, University of California at Berkeley.
  16. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, Elsevier, vol. 2(3), pages 231-237, December.
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Cited by:
  1. Martin Cincibuch & David Vavra, 2004. "Testing for the uncovered interest parity using distributions implied by FX options," Money Macro and Finance (MMF) Research Group Conference 2003, Money Macro and Finance Research Group 16, Money Macro and Finance Research Group.
  2. Aron Gereben, 2002. "Extracting market expectations from option prices?," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, Reserve Bank of New Zealand, vol. 65, March.
  3. Michelle Lewis, 2012. "Market Perceptions of Exchange Rate Risk," Reserve Bank of New Zealand Analytical Notes series, Reserve Bank of New Zealand AN2012/12, Reserve Bank of New Zealand.

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