Abstract
This paper describes a procedure for estimating the market's perceived probability distribution of future exchange rates from the prices of risk reversals, strangles and other currency options, and uses the procedure to estimate the risk neutral ex ante probability of a realignment of the pound sterling. The procedure for estimating the realignment probabilities relies on the jump-diffusion model of exchange rate behavior and the resulting option pricing formula. By fitting this model to market option price data, I retrieve the unobserved parameters of the jump-diffusion process. I then use these parameter estimates to estimate the ex ante probability distribution of exchange rates and thus the realignment probabilities.
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