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Market Expectations and Option Prices: Evidence for the Can$/US$ Exchange Rate


  • Alejandro Garcia
  • Andrei Prokopiw


Security prices contain valuable information that can be used to make a wide variety of economic decisions. To extract this information, a model is required that relates market prices to the desired information, and that ideally can be implemented using timely and low-cost methods. The authors explore two models applied to option prices to extract the risk-neutral probability density function (R-PDF) of the expected Can$/US$ exchange rate. Each of the two models extends the Black-Scholes model by using a mixture of two lognormals for the terminal distribution, instead of a single lognormal: one mixed lognormal imposes a specific stochastic process for the underlying asset, and the other does not. The contribution of the paper is to propose a simple methodology to build R-PDFs with a constant time to maturity in the absence of option prices for the maturity of interest. The authors apply this methodology and find that the two models provide similar results for the degree of uncertainty (i.e., the variance) surrounding the future level of the exchange rate, but differ on the likely direction of the exchange rate movements (i.e., the skewness).

Suggested Citation

  • Alejandro Garcia & Andrei Prokopiw, 2010. "Market Expectations and Option Prices: Evidence for the Can$/US$ Exchange Rate," Discussion Papers 10-2, Bank of Canada.
  • Handle: RePEc:bca:bocadp:10-2

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    References listed on IDEAS

    1. Matthew Harris & Raymond E. Owens & Pierre-Daniel G. Sarte, 2004. "Using manufacturing surveys to assess economic conditions," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 65-92.
    2. Ethan S. Harris, 1991. "Tracking the economy with the purchasing managers' index," Research Paper 9124, Federal Reserve Bank of New York.
    3. Harvey, David & Leybourne, Stephen & Newbold, Paul, 1997. "Testing the equality of prediction mean squared errors," International Journal of Forecasting, Elsevier, vol. 13(2), pages 281-291, June.
    4. Evan F. Koenig, 2002. "Using the Purchasing Managers' Index to assess the economy's strength and the likely direction of monetary policy," Economic and Financial Policy Review, Federal Reserve Bank of Dallas.
    5. Ethan S. Harris, 1991. "Tracking the economy with the purchasing managers' index," Quarterly Review, Federal Reserve Bank of New York, issue Aut, pages 61-69.
    6. Brigitte Desroches & Marc-André Gosselin, 2002. "The Usefulness of Consumer Confidence Indexes in the United States," Staff Working Papers 02-22, Bank of Canada.
    7. Isabel Yi Zheng & James Rossiter, 2006. "Using Monthly Indicators to Predict Quarterly GDP," Staff Working Papers 06-26, Bank of Canada.
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    More about this item


    Exchange rates; Econometric and statistical methods; Financial markets;

    JEL classification:

    • C00 - Mathematical and Quantitative Methods - - General - - - General
    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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