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Market perceptions of exchange rate risk

Michelle Lewis

From data on prices for foreign exchange options, which can be broadly thought of as insurance products, we can extract implied market perceptions of future exchange rate risk. Intuitively, if markets put much more weight on the probability of depreciation than of appreciation, the price of the respective options will reflect that difference. We can calculate the expected probability that the exchange rate will be above (or below) a given level in the future and see how these probabilities change over time.