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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.

Suggested Citation

  • Aron Gereben, 2002. "Extracting market expectations from option prices: an application to over-the-counter New Zealand dollar options," Reserve Bank of New Zealand Discussion Paper Series DP2002/04, Reserve Bank of New Zealand.
  • Handle: RePEc:nzb:nzbdps:2002/04
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    References listed on IDEAS

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    4. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-651, October.
    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", pages 125-132.
    7. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    8. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
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    10. 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, vol. 32(01), pages 91-115, March.
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    13. Lyons, Richard K., 1988. "Tests of the foreign exchange risk premium using the expected second moments implied by option pricing," Journal of International Money and Finance, Elsevier, vol. 7(1), pages 91-108, March.
    14. Bhupinder Bahra, 1997. "Implied risk-neutral probability density functions from option prices: theory and application," Bank of England working papers 66, Bank of England.
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    Cited by:

    1. Değerli, Ahmet & Fendoğlu, Salih, 2015. "Reserve option mechanism as a stabilizing policy tool: Evidence from exchange rate expectations," International Review of Economics & Finance, Elsevier, vol. 35(C), pages 166-179.
    2. 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 16, Money Macro and Finance Research Group.
    3. Aron Gereben, 2002. "Extracting market expectations from option prices?," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 65, March.
    4. Michelle Lewis, 2012. "Market Perceptions of Exchange Rate Risk," Reserve Bank of New Zealand Analytical Notes series AN2012/12, Reserve Bank of New Zealand.

    More about this item

    JEL classification:

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

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