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The forecast ability of risk-neutral densities of foreign exchange

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  • Craig, Ben R.
  • Keller, Joachim

Abstract

We estimate the process underlying the pricing of American options by using higher-order lattices combined with a multigrid method. This paper also tests whether the risk-neutral densities given from American options provide a good forecasting tool. We use a nonparametric test of the densities that is based on the inverse probability functions and is modified to account for correlation across time between our random variables, which are uniform under the null hypothesis. We find that the densities based on the Americanoption markets for foreign exchange do quite well for the forecasting period over which the options are thickly traded. Further, simple models that fit the densities do about as well as more sophisticated models.

Suggested Citation

  • Craig, Ben R. & Keller, Joachim, 2005. "The forecast ability of risk-neutral densities of foreign exchange," Discussion Paper Series 2: Banking and Financial Studies 2005,05, Deutsche Bundesbank.
  • Handle: RePEc:zbw:bubdp2:4260
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    References listed on IDEAS

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    1. Falko Fecht & Kevin X. D. Huang & Antoine Martin, 2008. "Financial Intermediaries, Markets, and Growth," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(4), pages 701-720, June.
    2. Hamerle, Alfred & Liebig, Thilo & Scheule, Harald, 2004. "Forecasting Credit Portfolio Risk," Discussion Paper Series 2: Banking and Financial Studies 2004,01, Deutsche Bundesbank.
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    More about this item

    Keywords

    Risk-neutral densities from option prices; American exchange rate options; Evaluating Density Forecasts; Pentionominal tree; Density evaluation; Overlapping data problem;

    JEL classification:

    • F47 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Forecasting and Simulation: Models and Applications
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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