ERM Realignment Risk and its Economic Determinants as Reflected in Cross‐rate Options

Abstract

This paper uses data on over-the-counter options between the mark and the pound, lira, French franc, and peseta to investigate the credibility of exchange rate target zones within the ERM. We compare empirical implications for the relation between option prices and the spot's position within the band for three classes of target zone models: those with full credibility, those with exogenous realignment risk, and those with endogenous realignment risk. Empirically, implied volatility from these options attains a maximum near the edges of an exchange rate band rather than its centre, even three to six months prior to realignment.