Exchange Rate Market Expectations and Central Bank Policy: The Case of the Mexican Peso/U.S. Dollar from 2005–2009

Abstract

That an implied volatility can be extracted from the market price for an option is well known. Less familiar is the fact that with a set of options with the same maturity and a range of strike prices, an estimate of the entire risk-neutral probability density (RND) can be extracted without the need to specify the market’s option pricing model. There are several alternative ways to do this in the literature, and the authors examine two of them. The behavior of the RND provides a detailed look at how the market’s (risk-neutral) expectations respond to important information events, such as a change in the interest rate target followed by the central bank. In this article, the authors look at how these monetary policy decisions by the U.S. Federal Reserve and the Banco de México are reflected in the market for FX options on the peso/U.S. dollar exchange rate. The results show that the exchange rate RNDs do respond significantly to interest rate surprises, and the extraction procedure that completes the RND by adding tails from a generalized extreme value distribution appears to have more success in capturing extreme values than does the alternative procedure that imposes a tail shape.

TOPICS: Options, tail risks, exchanges/markets/clearinghouses