Assessing Realignment Risk in the Exchange Rate Mechanism Through Pound-Mark Cross-Rate Options

This paper uses a new data source, options on the pound-mark cross-rate, to examine the credibility of the exchange rate band between the German mark and the British pound in the Exchange Rate Mechanism from October l990 through Ausust l992. Using two arbitrage-based tests, we provide clear evidence of imperfect credibility throughout much of this period and determine minimum bounds perceived by the market for the quot;intensityquot; of realignment, a measure incorporating both probability and magnitude of realignment. Finally, we identify a positive empirical relationship between implied volatility and the exchange rate's distance from the center of the band that proves useful for evaluating alternative theoretical models of target zones