Extracting information from options premia: the case of the return of the Italian lira to the ERM of the EMS

The prices of financial derivatives (forward contracts, futures and options) reflect, at each moment, the expectations of economic agents regarding the future path of the prices of the underlying assets. On the other hand, the price of the underlying assets (e.g., Treasury bills, Treasury bonds, stocks and commodities) reflect market expectations of the future path of their economic determinants. While forward and futures contracts provide information on the expected value of the prices of the underlying assets, options premia allow the estimation of the risk-neutral probability density function (PDF) of the prices of the underlying assets. In this context, the prices of financial derivatives contain potentially useful information for monetary authorities, namely in building indicators for monetary conditions, in assessing the impact of monetary policy actions, and to help detect anomalies in the functioning of the financial markets. These issues have been studied by several authors and central banks (see for instance Abken (1995), Bahra (1996), Deutsche Bundesbank (1995) and Soderlind and Svenson (1996)). Naturally, this information is also relevant from the viewpoint of portfolio and risk management by the private sector, and by financial institutions in particular. The comparison between the PDF of the price of a financial asset, estimated at different instants for a given maturity, provides a measure for the path of market expectations, and for its dispersion. For instance, Campa, Chang and Reider (1997) analyse the reaction of foreign exchange markets to the re-entrance of the Italian lira in the Exchange Rate Mechanism of the European Monetary System (ERM-EMS) on 25 November 1996, and find that the implicit exchange rate volatility of the Italian lira decreased with its re-entrance in the ERM-EMS. This finding is consistent with the idea that the change in the exchange rate regime aimed at stabilising the exchange rate. This study analyses the same episode, but using the premia of futures options of the 3-month interest rates of the Italian euro-lira(1). We use daily observations of the settlement prices for the call-options and put-options traded in the London International Financial Futures Exchange (LIFFE). The remainder of the paper is structured as follows: section 2 presents the most essential aspects of the estimation methodology; all technical details are left for Appendix. The third section applies the methodology and the last one concludes.