The Forecast Ability of Risk-Neutral Densities of Foreign Exchange

35 Pages Posted: 30 Oct 2007

See all articles by Ben R. Craig

Ben R. Craig

Federal Reserve Bank of Cleveland; Deutsche Bundesbank

Joachim Keller

Deutsche Bundesbank - Economic Research Centre

Multiple version iconThere are 2 versions of this paper

Date Written: November 2004

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 American option 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.

Keywords: American exchange rate options, density evaluation

JEL Classification: C52, C63, F31, F47

Suggested Citation

Craig, Ben R. and Keller, Joachim, The Forecast Ability of Risk-Neutral Densities of Foreign Exchange (November 2004). FRB of Cleveland Working Paper No. 04-09, Available at SSRN: https://ssrn.com/abstract=1025598 or http://dx.doi.org/10.2139/ssrn.1025598

Ben R. Craig (Contact Author)

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101
United States
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Deutsche Bundesbank

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Joachim Keller

Deutsche Bundesbank - Economic Research Centre ( email )

Wilhelm-Epstein-Strasse 14
Frankfurt/Main D-60431
Germany

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