Confidence building on euro convergence

Evidence from currency options

J.J.A.G. Driessen, E. Perotti

Research output: Contribution to journalArticleScientificpeer-review

Abstract

We study the evolution of investor confidence in 1992–1998 over the chance of individual currencies to converge to the Euro, using data on currency option prices. Convergence risk, which may reflect uncertainty over policy commitment as well as exogenous fundamentals, induces a level of implied volatility in excess of actual volatility. This volatility wedge should gradually decrease as confidence grows over time as convergence policy is maintained, and the risk of a reversal is progressively resolved. Empirically, we indeed find a positive volatility wedge which declines over time only for currencies involved in the Euro convergence process. The wedge and other convergence risk measures are correlated with both exogenous fundamentals and proxies for policy commitment uncertainty. We also find that the wedge responds to policy shocks in an asymmetric fashion, suggesting that policy risk is resolved at different rates after negative and positive shocks. Finally, we estimate a regime-switching model of convergence uncertainty, using data on interest rates, currency rates, and currency option prices. The results confirm the time-varying and asymmetric nature of convergence risk, and indicate that investors demand a risk premium for convergence risk.
Original languageEnglish
Pages (from-to)474-491
JournalJournal of International Money and Finance
Volume30
Issue number3
DOIs
Publication statusPublished - 2011

Fingerprint

Currency options
Confidence
Uncertainty
Currency
Investors
Option prices
Risk measures
Policy convergence
Implied volatility
Time-varying
Interest rates
Reversal
Risk premium
Regime-switching model

Cite this

@article{7a7fae76b5734e9887de081cbeeb1890,
title = "Confidence building on euro convergence: Evidence from currency options",
abstract = "We study the evolution of investor confidence in 1992–1998 over the chance of individual currencies to converge to the Euro, using data on currency option prices. Convergence risk, which may reflect uncertainty over policy commitment as well as exogenous fundamentals, induces a level of implied volatility in excess of actual volatility. This volatility wedge should gradually decrease as confidence grows over time as convergence policy is maintained, and the risk of a reversal is progressively resolved. Empirically, we indeed find a positive volatility wedge which declines over time only for currencies involved in the Euro convergence process. The wedge and other convergence risk measures are correlated with both exogenous fundamentals and proxies for policy commitment uncertainty. We also find that the wedge responds to policy shocks in an asymmetric fashion, suggesting that policy risk is resolved at different rates after negative and positive shocks. Finally, we estimate a regime-switching model of convergence uncertainty, using data on interest rates, currency rates, and currency option prices. The results confirm the time-varying and asymmetric nature of convergence risk, and indicate that investors demand a risk premium for convergence risk.",
author = "J.J.A.G. Driessen and E. Perotti",
year = "2011",
doi = "10.1016/j.jimonfin.2011.01.010",
language = "English",
volume = "30",
pages = "474--491",
journal = "Journal of International Money and Finance",
issn = "0261-5606",
publisher = "ELSEVIER SCI LTD",
number = "3",

}

Confidence building on euro convergence : Evidence from currency options. / Driessen, J.J.A.G.; Perotti, E.

In: Journal of International Money and Finance, Vol. 30, No. 3, 2011, p. 474-491.

Research output: Contribution to journalArticleScientificpeer-review

TY - JOUR

T1 - Confidence building on euro convergence

T2 - Evidence from currency options

AU - Driessen, J.J.A.G.

AU - Perotti, E.

PY - 2011

Y1 - 2011

N2 - We study the evolution of investor confidence in 1992–1998 over the chance of individual currencies to converge to the Euro, using data on currency option prices. Convergence risk, which may reflect uncertainty over policy commitment as well as exogenous fundamentals, induces a level of implied volatility in excess of actual volatility. This volatility wedge should gradually decrease as confidence grows over time as convergence policy is maintained, and the risk of a reversal is progressively resolved. Empirically, we indeed find a positive volatility wedge which declines over time only for currencies involved in the Euro convergence process. The wedge and other convergence risk measures are correlated with both exogenous fundamentals and proxies for policy commitment uncertainty. We also find that the wedge responds to policy shocks in an asymmetric fashion, suggesting that policy risk is resolved at different rates after negative and positive shocks. Finally, we estimate a regime-switching model of convergence uncertainty, using data on interest rates, currency rates, and currency option prices. The results confirm the time-varying and asymmetric nature of convergence risk, and indicate that investors demand a risk premium for convergence risk.

AB - We study the evolution of investor confidence in 1992–1998 over the chance of individual currencies to converge to the Euro, using data on currency option prices. Convergence risk, which may reflect uncertainty over policy commitment as well as exogenous fundamentals, induces a level of implied volatility in excess of actual volatility. This volatility wedge should gradually decrease as confidence grows over time as convergence policy is maintained, and the risk of a reversal is progressively resolved. Empirically, we indeed find a positive volatility wedge which declines over time only for currencies involved in the Euro convergence process. The wedge and other convergence risk measures are correlated with both exogenous fundamentals and proxies for policy commitment uncertainty. We also find that the wedge responds to policy shocks in an asymmetric fashion, suggesting that policy risk is resolved at different rates after negative and positive shocks. Finally, we estimate a regime-switching model of convergence uncertainty, using data on interest rates, currency rates, and currency option prices. The results confirm the time-varying and asymmetric nature of convergence risk, and indicate that investors demand a risk premium for convergence risk.

U2 - 10.1016/j.jimonfin.2011.01.010

DO - 10.1016/j.jimonfin.2011.01.010

M3 - Article

VL - 30

SP - 474

EP - 491

JO - Journal of International Money and Finance

JF - Journal of International Money and Finance

SN - 0261-5606

IS - 3

ER -