IMPLIED EXCHANGE-RATE DISTRIBUTIONS - EVIDENCE FROM OTC OPTION MARKETS

This paper uses a rich new dataset of option prices on the dollar-mark , dollar-yen, and key EMS cross-rates to extract the entire risk-neutr al probability density function (pdf) over horizons of 1 and 3 months. We compare three alternative smoothing methods - cubic splines, an im plied binomial tree (trimmed and untrimmed), and a mixture of lognorma ls - for transforming option data into the pdf. Despite their methodol ogical differences, the three approaches lead to a similar pdf clearly distinct from the lognormal benchmark, and typically characterized by skewness and leptokurtosis. We then document a striking positive corr elation between skewness in these pdfs and the spot rate. The stronger a currency the more expectations are skewed towards a further appreci ation of that currency. We interpret this finding as a rejection that innovations in these exchange rates are independent of the level, or c haracteristic of a credible target zone, explicit or implicit. Instead , this positive correlation is consistent with target zones with endog enous realignment risk. We discuss two interpretations of our results on skewness: when a currency is stronger, the actual probability of fu rther large appreciation is higher, or because of risk, such states ar e valued more highly. (C) 1998 Elsevier Science Ltd. All rights reserv ed.