Using option prices to estimate realignment probabilities in the European Monetary System

Risk reversals are a combination of options from which price information about market expectations of future exchange rates can be extracted. This paper describes a procedure for estimating the market's perceived probability distribution of future exchange rates from the prices of risk reversals and other currency options. This procedure is used to estimate the ex ante probability of a realignment of the French franc and pound sterling. The procedure for estimating the realignment probabilities relies on the jump-diffusion model of exchange rate behavior and the resulting option pricing formula. By fitting this model to market option price data, the unobserved parameters of the jump-diffusion process are retrieved. These parameter estimates form the basis for estimating the ex ante probability distribution of exchange rates and thus the realignment probabilities.