USING OPTION PRICES TO ESTIMATE REALIGNMENT PROBABILITIES IN THE EUROPEAN MONETARY-SYSTEM - THE CASE OF STERLING-MARK

This pager describes a procedure for estimating the market's perceived probability distribution of future exchange rates from the prices of risk reversals, strangles and other currency options, and uses the pro cedure to estimate the risk neutral ex ante probability of a realignme nt of the pound sterling. The procedure for estimating the realignment probabilities relies on the jump-diffusion model of exchange rate beh avior and the resulting option pricing formula. By fitting this model to market option price data, I retrieve the unobserved parameters of t he jump-diffusion process. I then use these parameter estimates to est imate the ex ante probability distribution of exchange rates and thus the realignment probabilities. Copyright (C) 1996 Elsevier Science Ltd