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Recovering Risk-Neutral Densities from Exchange Rate Options: Evidence in Turkey (Kur Opsiyonlarindan Riske Duyarsiz Yogunluk Fonksiyonu Cikarimi: Turkiye Ornegi)

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  • Halil Ibrahim Aydin
  • Ahmet Degerli
  • Pinar Ozlu

Abstract

This paper uses over-the-counter currency options data to investigate market expectations on Turkish Lira-U.S. Dollar exchange rate. We extract option implied density functions to examine the evolution of market sentiment over the possible values of future exhange rates. Uncertainty is well measured by option-implied probabilities. Estimated densities for selected days point out an increase in uncertainty in foreign exchange market during financial turbulence periods. We make inferences about the effectiveness of policy measures and see how the market perception changed throughout the crisis. We uncover the effectiveness of policy measures by observing shrinking densities and confidence bands.

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Bibliographic Info

Paper provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its series Working Papers with number 1003.

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Date of creation: 2010
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Handle: RePEc:tcb:wpaper:1003

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Keywords: Options; Risk neutral density; Market expectations;

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References

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  1. Söderlind, Paul & Svensson, Lars E O, 1997. "New Techniques to Extract Market Expectations from Financial Instruments," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1556, C.E.P.R. Discussion Papers.
  2. Adam Szeidl, 2005. "Comment on "Macroeconomic Derivatives: An Initial Analysis of Market-Based Macro Forecasts, Uncertainty, and Risk"," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER International Seminar on Macroeconomics 2005, pages 60-64 National Bureau of Economic Research, Inc.
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  4. 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.
  5. 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.
  6. Ramaprasad Bhar & Carl Chiarella, 2000. "Expectations of monetary policy in Australia implied by the probability distribution of interest rate derivatives," The European Journal of Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 6(2), pages 113-125.
  7. Jondeau, Eric & Rockinger, Michael, 2000. "Reading the smile: the message conveyed by methods which infer risk neutral densities," Journal of International Money and Finance, Elsevier, Elsevier, vol. 19(6), pages 885-915, December.
  8. 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.
  9. Nakamura, Hisashi & Shiratsuka, Shigenori, 1999. "Extracting Market Expectations from Option Prices: Case Studies in Japanese Option Markets," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, Institute for Monetary and Economic Studies, Bank of Japan, vol. 17(1), pages 1-43, May.
  10. Refet Gurkaynak & Justin Wolfers, 2006. "Macroeconomic Derivatives: An Initial Analysis of Market-Based Macro Forecasts, Uncertainty, and Risk," NBER Working Papers 11929, National Bureau of Economic Research, Inc.
  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.
  12. Campa, Jose M. & Chang, P. H. Kevin & Reider, Robert L., 1998. "Implied exchange rate distributions: evidence from OTC option markets1," Journal of International Money and Finance, Elsevier, Elsevier, vol. 17(1), pages 117-160, February.
  13. 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.
  14. Csaba Csávás, 2008. "Density forecast evaluation and the effect of risk-neutral central moments on the currency risk premium: tests based on EUR/HUF option-implied densities," MNB Working Papers, Magyar Nemzeti Bank (the central bank of Hungary) 2008/3, Magyar Nemzeti Bank (the central bank of Hungary).
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  16. 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.
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