A Note on Estimating Realignment Probabilities - A First-Passage-Time Approach

10 Pages Posted: 11 Jun 2008 Last revised: 18 May 2009

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

Date Written: 2009

Abstract

This paper proposes a path-dependent approach for estimating realignment probabilities of targeted exchange rates based on first-passage-time distributions instead of the commonly used path-independent approach. We consider that path dependency is an intrinsic characteristic of realignment risk because a realignment of an exchange rate can occur whenever a committed band by a central bank is breached. A mean-reverting lognormal process is considered in the first-passage-time approach. Based on market data of the British pound and mark during the ERM crisis of 1992, the realignment probabilities of the pound estimated under the proposed approach show that path dependency is quantitatively significant, compared with the path-independent approach.

Keywords: realignment risk, mean-reversion, first-passage-time probability

JEL Classification: F31, G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai, A Note on Estimating Realignment Probabilities - A First-Passage-Time Approach (2009). Journal of International Money and Finance, Vol. 28, pp. 804-812, 2009. Available at SSRN: https://ssrn.com/abstract=1143323

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

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