Assessing Realignment Risk in the Exchange Rate Mechanism Through Pound-Mark Cross-Rate Options
Posted: 24 Aug 1998
This paper uses a new data source, options on the pound-mark cross-rate, to examine the credibility of the exchange rate band between the German mark and the British pound in the Exchange Rate Mechanism from October l990 through Ausust l992. Using two arbitrage-based tests, we provide clear evidence of imperfect credibility throughout much of this period and determine minimum bounds perceived by the market for the "intensity" of realignment, a measure incorporating both probability and magnitude of realignment. Finally, we identify a positive empirical relationship between implied volatility and the exchange rate's distance from the center of the band that proves useful for evaluating alternative theoretical models of target zones.
JEL Classification: G13
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