Option-Implied Probability Distributions and Currency Excess Returns

61 Pages Posted: 9 Nov 2006

Date Written: November 1997

Abstract

This paper describes a method of extracting the risk-neutral probability distribution of future exchange rates from option prices. In foreign exchange markets interbank option pricing conventions make possible reliable inferences about risk-neutral probability distributions with relatively little data. Moments drawn from risk-neutral exchange rate distribution are used to explore several issues related to the puzzle of excess returns in currency markets. Tests of the international capital asset pricing model using risk-neutral moments as explanatory variables indicate that option-based moments have considerably greater explanatory power for excess returns in currency markets than has been found in earlier work. Tests of several hypotheses generated by the peso problem approach indicate that jump risk measured by the risk-neutral coefficient of skewness can explain only a small part of the forward bias. These tests take into account not only the second, but the third and fourth moments of the exchange rate implied by option prices, and avoid testing a joint hypothesis including a distributional assumption.

Keywords: exchange rates, option pricing

JEL Classification: F31, F33, G13, G15

Suggested Citation

Malz, Allan M., Option-Implied Probability Distributions and Currency Excess Returns (November 1997). FRB of New York Staff Report No. 32, Available at SSRN: https://ssrn.com/abstract=943500 or http://dx.doi.org/10.2139/ssrn.943500

Allan M. Malz (Contact Author)

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