Implied Exchange Rate Distributions: Evidence from OTC Option Markets

Jose Campa, P.H. Kevin Chang and Robert L. Reider

No 6179, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper uses a rich new data set of option prices on the dollar-mark, dollar-yen, and key EMS cross-rates to extract the entire risk-neutral probability density function (pdf) over horizons of one and three months. We compare three alternative smoothing methods---cubic splines, an implied binomial tree (trimmed and untrimmed), and a mixture of lognormals---for transforming option data into the pdf. Despite their methodological ifferences, the three approaches lead to a similar pdf distinct from the lognormal benchmark, and usually characterized by skewness and leptokurtosis. We then document a striking positive correlation between skewness in these pdfs and the spot rate. The stronger a currency the more expectations are skewed towards a further appreciation of that currency. We interpret this finding as a rejection that these exchange rates evolve as a martingale, or that they follow a credible target zone, explicit or implicit. Instead, this this positive correlation is consistent with target zones with endogenous realignment risk. We discuss two interpretations of our results on skewness: when a currency is stronger, the actual probability of further large appreciation is higher, or because of risk, such states are valued more highly.

Date: 1997-09
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

Published as Journal of International Money and Finance, Vol. 17, no. 1 (February 1998): 117-160.

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