DP4180 | Confidence Building on Euro Conversion: Theory and Evidence from Currency Options

Publication Date

23/01/2004

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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.