BEERVE BANK OF NEW YORKOption-implied probability distributions and currency excess returns’ Allon M. Male Markets Group. Federal Reserve Bank of New York 38 Liberty Street Now York, NY 10045-0001 tel. 212 7203675 fx 212 720 6827 emai: allan malaGny eb org ‘Tas DRAFT: July 1997 inst DRAFT: July 1995 Avstesct ‘This paper describes « method of extracting the sskneutral probability distribution of fu ture exchange rates from option prices. In foreign exchange markets interbank option pricing ‘conventions make posable reiable inferences about rsk-neutal probability distributions with Felatively lite data. Moment drawn from risk-neutral exchange rate distribution are wied 0 ‘Soloreeevera enn related to Use puzae of excess returns in currency markets, ‘Tests ofthe International capital set pricing model ssing risk neutral moments as explanatory variables indicate thet option-based momenta have considerably greater explanatory power for excess e+ turn in curtency market than haa been found in eater work Teata of several hypotheses {enerated by the peo problem approach indicate that jump risk measured by the risk-neutral Soult of skewness Can explain only a mall prt ofthe forward bias. These tects take into ecount not only the escond, but the thd and fourth momenta ofthe exchange rate implied by ‘ption prions, and avold tating joint hypothesis including a ditelbutionel assumption. JBL classifcations: F31, P33, G13, G18 ‘Keywords: Exchange rates, option pricing “The eutbor acknowledge helpful dacunions with Christophe Blt Antaine Pachot, Dale Henderson, Karen Lewin, Rich Lyons, lan MeCileady, Wil Melek, ara Olena, Rob Rater, Joka Sle, Peal Sodertind, Chaiie ‘Twas, and waar prtcipnte nt te Peerl Reserve Bask of New York, the Federal Reserve Bona the itera ‘ional Sntary Fund, te Baak fo International Seca, Goldman, Sacha and Co Column University, nod ‘he 1896 Exooometrc Society Buopeen Meeting. James Robb and Tao Ki caried out tbe MATLAB programing ‘sod calcltions. The views exprened ia tha paper are thos ofthe nuthr and do not necsalytelct thse of {he Federal Reserve Bank of New Yor1 Introduction ‘Market participants and policy makers require up-to-dste information on market sentiment and market beliefs about the future, This i probability distributions of fnancil asset prices. The prices of the assets themsclves and the prices of derivative contracts on the assets contain much of that information. A clasic example ia the use of the forward exchange rate as an indicator of the market consensus on the first moment of the formation can be compactly expressed in terms of the future exchange rate; enother isthe use of the term structure of Interest rates as an indicator of the expected future infation rate “The payofls on derivatives such as options are conditional onthe future prices of the underlying essets, and therefore reflect market belief about the future prices of the underlying esses. ‘This paper describes a method for extracting the risk-neutral probability distribution of future exchange rates from option prices which exploits the Identity of the second derivative of a call option’s value with respect to the exercise price and the risk-neutral probability density funetion. We use ‘a relatively small amount of data—essentally,throe different exercise prices—to draw inferences ‘about the complete probability distribution. In foreign exchange markete, most option trading takes place over-the-counter, and we will so, the way these markets package options and the pricing conventions they employ make it possible to draw reliable inforences about risk-neutral probability distributions using these few data point, Risk neutral probability distributions may shed vome light on along standing puzzle in exchange rate economics, the forward rate bias. ‘This paper reports tests of the international capital asect pricing mode! (CAPM) using risk-neutral moments as explanatory variables fndicate that option- ‘based momenta have considerably greater explanatory power for excess returns in currency markets than has been found in erlier work. We also find that investors can earn excess returns fom holding, cies for which option prices indicate positive skewness, although such a strategy may be quite risky. Theee tests take into account the higher moments of the exchange rate implied by option prices, and avold testing a joint hypothesis including a distributional assumption.