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Implied Exchange Rate Distributions: Evidence from OTC Option Markets

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

NBER Working Paper No. 6179
Issued in September 1997
NBER Program(s):International Finance and Macroeconomics Program

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.

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Document Object Identifier (DOI): 10.3386/w6179

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

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