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A Note on Estimating Realignment Probabilities -- A First-Passage-Time Approach

Author

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  • Cho-Hoi Hui

    (Research Department, Hong Kong Monetary Authority)

  • Chi-Fai Lo

    (Research Department, Hong Kong Monetary Authority)

Abstract

This paper proposes a path-dependent approach for estimating realignment probabilities of targeted exchange rates based on first-passage-time distributions instead of the commonly used path-independent approach. We consider that path dependency is an intrinsic characteristic of realignment risk because a realignment of an exchange rate can occur whenever a committed band by a central bank is breached. A mean-reverting lognormal process is considered in the first-passage-time approach. Based on market data of the British pound and mark during the ERM crisis of 1992, the realignment probabilities of the pound estimated under the proposed approach show that path dependency is quantitatively significant, compared with the path-independent approach.

Suggested Citation

  • Cho-Hoi Hui & Chi-Fai Lo, 2008. "A Note on Estimating Realignment Probabilities -- A First-Passage-Time Approach," Working Papers 0809, Hong Kong Monetary Authority.
  • Handle: RePEc:hkg:wpaper:0809
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    File URL: http://www.info.gov.hk/hkma/eng/research/working/pdf/HKMAWP08_09_full.pdf
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    References listed on IDEAS

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    Cited by:

    1. Genberg, Hans & Hui, Cho-Hoi, 2008. "The credibility of 'The Link' from the perspective of modern financial theory," IMFS Working Paper Series 18, Goethe University Frankfurt, Institute for Monetary and Financial Stability (IMFS).

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    More about this item

    Keywords

    realignment risk; mean-reversion; first-passage-time probability;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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