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Density forecast evaluation and the effect of risk-neutral central moments on the currency risk premium: tests based on EUR/HUF option-implied densities

Author

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  • Csaba Csávás

    () (Magyar Nemzeti Bank)

Abstract

In this paper we estimate risk-neutral probability density functions from EUR/HUF currency options using the Malz (1997) method. First, we compare different option-based indicators. We present so-called 'shortcut' indicators, i.e. indicators that can be calculated directly, without the estimation of RNDs, but which show strong co-movement with the central moments of estimated densities. We also find that it is possible to construct probability-based indicators, which again exhibit strong correlation with the central moments. We present evidence that risk-neutral densities do not provide accurate forecasts for the distribution of the historical EUR/HUF exchange rate. The higher moments of risk-neutral densities are responsible for the rejection of forecasting ability. Our interpretation is that the standard deviation, the skewness and the kurtosis of the risk-neutral densities are significantly higher than the central moments of subjective densities. Finally, we show that the higher moments of risk-neutral densities are able to explain a significant part of the variability in the estimated risk premium. These latter results suggest that risk-neutral standard deviation and skewness can be used as proxy variables for the respective central moments of subjective densities.

Suggested Citation

  • 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 2008/3, Magyar Nemzeti Bank (Central Bank of Hungary).
  • Handle: RePEc:mnb:wpaper:2008/3
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    Cited by:

    1. Halil Ibrahim Aydin & Ahmet Degerli & Pinar Ozlu, 2010. "Recovering Risk-Neutral Densities from Exchange Rate Options: Evidence in Turkey (Kur Opsiyonlarindan Riske Duyarsiz Yogunluk Fonksiyonu Cikarimi: Turkiye Ornegi)," Working Papers 1003, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.

    More about this item

    Keywords

    currency option; implied risk-neutral density function; density forecasting; risk premium; GMM.;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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