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

Posted: 23 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 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

Suggested Citation

Campa, José Manuel and Chang, P.H. Kevin, Arbitrage-Based Tests of Target Zone Credibility: Evidence from Erm Cross-Rate Options. Available at SSRN: https://ssrn.com/abstract=6812

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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