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ERM bandwidths for EMU and after: evidence from foreign exchange options

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  • José M. Campa
  • P.H. Kevin Chang
  • Robert L. Reider

Abstract

Summary EMS credibility Exchange rate expectations implied by derivatives pricesAre the wide bands adopted in the summer of 1993 too large? The official answer is that wide bands offer a protection against speculative pressure, while exchange rates may be kept within narrower margins at the discretion of the authorities. Yet if exchange rate fixity and predictability are desirable, as implicitly assumed by the mere existence of the system, there must exist a trade-off between protection against speculative pressure and predictability. In that case, the bandwidth chosen should be as narrow as possible and yet unlikely to be challenged by the markets. This paper offers estimates of ‘safe’ bandwidths. For the long-term member currencies (French franc, peseta, Danish krone and escudo), the existing 15% bands are found to be unnecessarily wide: narrower 3.5% bands would capture at least 95% of expected exchange rate realizations over a three-month horizon. For the lira, Finnish markka and Swedish krone, wider bands of 5–6% would capture a similar amount of the exchange rate distribution. The pound's exchange rate expectations are the most dispersed, requiring 8.4% bands to capture 95% of exchange rate expectations.–José M. Campa, P. H. Kevin Chang and Robert L. Reider

Suggested Citation

  • José M. Campa & P.H. Kevin Chang & Robert L. Reider, 1997. "ERM bandwidths for EMU and after: evidence from foreign exchange options," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 12(24), pages 53-89.
  • Handle: RePEc:oup:ecpoli:v:12:y:1997:i:24:p:53-89.
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    File URL: http://hdl.handle.net/10.1111/1468-0327.00016
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    Cited by:

    1. Steven A. Weinberg, 2001. "Interpreting the volatility smile: an examination of the information content of option prices," International Finance Discussion Papers 706, Board of Governors of the Federal Reserve System (U.S.).
    2. José Manuel Campa & P.H. Kevin Chang & James F. Refalo, 1999. "An Options-Based Analysis of Emerging Market Exchange Rate Expectations: Brazil's Real Plan, 1994-1997," Working Papers 99-08, New York University, Leonard N. Stern School of Business, Department of Economics.
    3. David S. Bates, 1999. "Financial Markets' Assessment of EMU," NBER Working Papers 6874, National Bureau of Economic Research, Inc.
    4. Bernardino Adão & Jorge Barros Luís & Nuno Cassola, 1998. "Information on expectations about the escudo convergence from the volatility implied in currency options," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    5. Bernardino Adão & Jorge Barros Luís & Nuno Cassola, 1997. "Extracting information from options premia: the case of the return of the Italian lira to the ERM of the EMS," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    6. Jose M. Campa & P.H. Kevin Chang & Robert L. Reider, 1997. "Implied Exchange Rate Distributions: Evidence from OTC Option Markets," NBER Working Papers 6179, National Bureau of Economic Research, Inc.

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