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Confidence Building on Euro Conversion: Theory and Evidence from Currency Options

Author

Listed:
  • Perotti, Enrico
  • Driessen, Joost
Abstract
Using a new dataset of currency option prices, we study the evolution of investor confidence in 1992-98 over the chance of individual currencies to converge to the euro. 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 (volatility wedge). We show formally that 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 that declines over time, only for those currencies involved in convergence. The wedge and other convergence risk measures are correlated with both observable 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, as the confidence-building model suggests. 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.

Suggested Citation

  • Perotti, Enrico & Driessen, Joost, 2004. "Confidence Building on Euro Conversion: Theory and Evidence from Currency Options," CEPR Discussion Papers 4180, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:4180
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    References listed on IDEAS

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    Cited by:

    1. Perotti, Enrico & Soons, Oscar, 2019. "The Political Economy of a Diverse Monetary Union," CEPR Discussion Papers 13987, C.E.P.R. Discussion Papers.

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    More about this item

    Keywords

    Convergence risk; Confidence building; Currency options; Regime-switching models;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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