Extracting Expectations about 1992 UK Monetary Policy from Option Prices

The UK pound left the ERM on 16 September 1992 after a period of turbulence. UK monetary policy soon shifted to lower short interest rates and an inflation target was announced. This paper uses daily option prices to estimate how the market’s probability distribution of the future Deutsche mark/sterling exchange rate and UK and German interest rates changed over the summer and autumn of 1992. The results show, among other things, how various policy decisions affected the market’s assessment of the probabilities of realignments and lending rate cuts.