Extracting information from asset prices: The methodology of EMU calculators

This paper develops a particular technique for extracting market expectatio ns from asset prices. We use the term structure of interest rates to estima te the probability the market attaches to the event that a country, Italy, joins the European Monetary Union at a given date. The case of Italy is int eresting because in the survey regularly conducted by Reuters, the probabil ity that Italy joins EMU in 1999 has fluctuated, in the first months of 199 7, between 0.07 and 0.15, while, during the same period, the measures compu ted by financial houses - which art: based on the term structure of interes t rates - ranged between 0.5 and 0.8. The paper proposes a new method for c omputing these probabilities. and shows that the discrepancies between surv ey and market-based measures are not the result of market inefficiencies, b ut depend on an incorrect use of the term structure to compute probabilitie s. The technique proposed in the paper can also be used to distinguish betw een convergence of probabilities and convergence of fundamentals, that is t o find out whether an observed reduction in interest rate spreads signals a higher probability of joining EMU at a given date, or simply reflects impr oved fundamentals. It could also be applied, more generally, to extract fro m assets prices, information on imminent changes in an exchange rate regime . (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: E 43; E52.