Arbitrage-Based Tests of Target Zone Credibility: Evidence from Erm Cross-Rate Options

Abstract

This paper introduces two arbitrage-based tests of target zone credibility using a new data source, ERM cross-rate options. We use daily option prices from September 1991 to August 1994 to assess the credibility of the pound-mark and mark-lira target zones that collapsed September 1992, and the ongoing mark-French franc target zone. These tests are based on restrictions that must apply to all option prices within a credible target zone. Since they rely only on arbitrage, our tests have the advantages of being free from specification error and estimation error. Our approach enables us to identify a minimum "intensity of realignment," an expression indicating the probability-weighted average realignment size. We also show that current option prices are consistent with considerably narrower mark-franc bands than the current 15%.

JEL Classification: F3, F31, G15