Extracting market expectations from option prices : an application to over-the-counter New Zealand dollar options
What are the odds of a large shift in the exchange rate? Is a large depreciation more likely than a large appreciation? This paper uses over-the-counter New Zealand dollar/US dollar option prices to quantify market expectations of exchange rate uncertainty through measures based on risk-neutral probability distribution functions. Results suggest that the estimated probability distributions can provide important insights into market perceptions about exchange rate risk in the future. Econometric evidence indicates that the higher moments calculated from risk-neutral probability density functions can be used to explain the dynamic behaviour of the forward bias measured in the New Zealand dollar/US dollar exchange rate.