Can the price of currency options provide an indication of market perceptions of the uncertainty attached to the krone exchange rate?

Abstract

Prices in the currency options market can provide an indication of market perceptions of the uncertainty attached to future exchange rates. We have used these option prices to calculate the probability distribution for the krone exchange rate against the Deutsche mark since 1 January 1998. Until August 1998, the market expected relatively low volatility in the krone exchange rate, and the probability of an appreciation or a depreciation of the krone was considered to be virtually the same. The krone depreciated during the autumn of 1998 and uncertainty surrounding future movements of the krone exchange rate increased substantially. At the same time, the prevailing view among market participants seemed to be that a considerable depreciation of the krone was more probable than a corresponding appreciation. This volatility subsided during the spring of 1999 to about the level prior to the depreciation of the krone in the autumn of 1998. The estimated probability distribution for the krone exchange rate at end-May was approximately equal to the corresponding distribution in July of last year, ie the market assessment of krone exchange rate uncertainty seems to be about the same as it was prior to the currency unrest in the autumn of 1998.