Option Prices, Exchange Market Intervention, and the Higher Moment Expectations Channel: A User's Guide

48 Pages Posted: 18 Oct 2007

See all articles by Gabriele Galati

Gabriele Galati

De Nederlandsche Bank

Patrick C. Higgins

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Owen Humpage

Federal Reserve Bank of Cleveland

William R. Melick

Kenyon College

Date Written: December 2006

Abstract

A vast literature on the effects of sterilized intervention by the monetary authorities in the foreign exchange markets concludes that intervention systematically moves the spot exchange rate only if it is publicly announced, coordinated across countries, and consistent with the underlying stance of fiscal and monetary policy. Over the past fifteen years, researchers have also attempted to determine if intervention has any effects on the dispersion and directionality of market views concerning the future exchange rate. These studies usually focus on the variance around the expected future exchange rate - the second moment. In this paper we demonstrate how to use over-the-counter option prices to recover the risk-neutral probability density function (PDF) for the future exchange rate. Using the yen/dollar exchange rate as an example, we calculate measures of dispersion and directionality, such as variance and skewness, from estimated PDFs to test whether intervention by the Japanese Ministry of Finance had any impact on the higher moments of the exchange rate. We find little or no systematic effect, consistent with the findings of the literature on the spot rate as Japanese intervention during the period 1996-2004 was not publicly announced, rarely coordinated across countries and, in hindsight, probably inconsistent with the underlying stance of monetary policy.

Keywords: exchange rate intervention, monetary policy, risk-neutral probability density function

JEL Classification: F3, G15

Suggested Citation

Galati, Gabriele and Higgins, Patrick C. and Humpage, Owen and Melick, William R., Option Prices, Exchange Market Intervention, and the Higher Moment Expectations Channel: A User's Guide (December 2006). FRB of Cleveland Working Paper No. 06-18. Available at SSRN: https://ssrn.com/abstract=1022173 or http://dx.doi.org/10.2139/ssrn.1022173

Gabriele Galati

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

Patrick C. Higgins

Federal Reserve Banks - Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

Owen Humpage (Contact Author)

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101-1387
United States

William R. Melick

Kenyon College ( email )

Gambier, OH 43022

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