Assessing Realignment Risk in the Exchange Rate Mechanism Through Pound-Mark Cross-Rate Options

Posted: 24 Aug 1998

See all articles by José Manuel Campa

José Manuel Campa

University of Navarra - Madrid Campus - IESE Business School; National Bureau of Economic Research (NBER)

P. H. Kevin Chang

Credit Suisse AG - London Headquarters

Abstract

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

Suggested Citation

Campa, José Manuel and Chang, P.H. Kevin, Assessing Realignment Risk in the Exchange Rate Mechanism Through Pound-Mark Cross-Rate Options. Available at SSRN: https://ssrn.com/abstract=6731

José Manuel Campa (Contact Author)

University of Navarra - Madrid Campus - IESE Business School ( email )

Camino del Cerro del Aguila 3
Madrid, 28023
Spain
+34 91 357 0809 (Phone)
+34 91 357 2913 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

P.H. Kevin Chang

Credit Suisse AG - London Headquarters ( email )

One Cabot Square
London E14 4QJ
United Kingdom
+44 171 888 8535 (Phone)
+44 171 888 4775 (Fax)

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