Using Option Prices to Estimate Realignment Probabilities in the European Monetary System

The paper presents a method of computing the risk neutral probability distribution of future exchange rates from the prices of currency options. The method is applied to estimate the risk neutral ex ante probability of a realignment of the pound sterling against the mark in 1992. The computation fits a jump-diffusion model of exchange rate behavior to market option price data, including at-the-money options as well as risk reversals and strangles, to retrieve the unobserved parameters of the jump-diffusion process