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Market Expectations Implicit in Derivative Prices: Applications to Exchange and Oil Markets

Author

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  • Alejandro Díaz de León
  • Martha Elena Casanova

Abstract

The paper’s objective is to identify the balance of risks that economic agents incorporate in oil and exchange rate markets (peso/US dollar). For that purpose, two methodologies that are normally used to estimate the expected risk-neutral probability functions for a determinate underlying asset, from option market price quotations, are used: a) the lognormal mix parametric method, to analyze the balance of risks for the oil market during the first quarter of 2003 (period in which the oil price was affected by the Iraq conflict); and, b) the non-parametric method, interpolation of the smile curve, to obtain the risk-neutral probability function for the peso/US dollar exchange rate. The latter methodology is also used to propose a definition of exchange rate risk premium, which compensates investors for the peso-depreciation bias and the higher probability of extreme variations that is observed in the estimated risk-neutral probability functions.

Suggested Citation

  • Alejandro Díaz de León & Martha Elena Casanova, 2004. "Market Expectations Implicit in Derivative Prices: Applications to Exchange and Oil Markets," Working Papers 2004-01, Banco de México.
  • Handle: RePEc:bdm:wpaper:2004-01
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    File URL: http://www.banxico.org.mx/publicaciones-y-discursos/publicaciones/documentos-de-investigacion/banxico/%7B6DF288F7-E073-2B6C-00AD-19D2F694C4AA%7D.pdf
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    More about this item

    Keywords

    risk-neutral densities; options; exchange rate; oil price;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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